Markets

The Kelly Formula in Value Investing

In 1956, John Kelly of AT&T AAAs ( T ) Bell Labs published AAA A New Interpretation of Information Rate[1 ] .AAA This publication discusses the criteria and formula that assisted AT&T with its long distance telephone signal noise. After its publication, individuals who engaged in betting realized the potential of his work. Talk about intellectual cross-pollination! The Kelly Formula allowed gamblers to optimize the sizes of their bets in the long term. Since then the formula has found a strong group of proponents in the investment world.

The criteria

The Kelly Criteria are actually relatively simple in their design. There are two components that make up the basis of the formula. The first is the probability that your transaction will produce a profitable return. This is called the win probability. The second is the total dollar amount of transactions with positive returns divided by total amount of transactions with negative returns. This is called the win/loss ratio.

The formula

The actual Kelly Formula utilizes both of these criteria in its calculations. The formula gives the investor the Kelly Percentage AAA or what percentage the transaction should take up in your portfolio. LetAAAs start with formula itself.

Kelly % = W AAA [(1 AAA W)/R]

W represents the win probability and R represents the win/loss ratio. To get the numbers required to populate the equation, the following steps are required.

  1. Collect data on your previous 50 trades.
  2. Calculate the winning probability by dividing positive return transactions by negative return transactions.
  3. Calculate the win/loss ratio by dividing the total gains from your positive return transactions by the total losses of your negative return transactions.
  4. Plug these numbers into the formula and the Kelly percentage represents the percentage that this transaction should amount to in your portfolio.

Some thoughts on the formula

ItAAAs far beyond the purview of this article to comprehensively address the pros and cons of the formula. However, at the Nintai Charitable Trust we employ the Kelly Formula as a piece in an integrated capital deployment strategy. Simply put, it plays a very diminished role in our capital allocation decisions. Over the course of our investment management career weAAAve had many individuals ask why we donAAAt use the formula to a greater degree in our portfolio selection.

The short answer is I believe the formula gives an investor a partial AAA and wholly incomplete AAA picture of the capital allocation process. The idea of your largest position being dictated by a formulaic approach is compelling. In games of chance it is even more so. Allowing your allocation of capital to be decided by such an approach alone gives away the great advantage one has as an investment manager.

Whist versus bridge

Anybody who plays whist and bridge knows there is a vast difference in the role of luck between them. In bridge, partners communicate with each other through a detailed bidding process that discusses both strength of their hands and their preferred suit. In whist, players communicate about points but cannot

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This article first appeared on GuruFocus .

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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