Kelly Criterion- A Warren Buffet Used Investment Analyzing Formula

Everyone seeks to earn a hefty sum of money as well as maximize the long-term growth of capital. All they require is to calculate the expected return to benefit their money value and bankroll.

On the other hand, the calculation of long-term wealth should minimize uncertainty. Therefore, Kelly L.J has developed a theoretical statistical method to measure expected return value in the future, by adjusting the investment size with the use of the Kelly criterion.

People flummox themselves with the Kelly criterion and return on Investment formula. So the difference between these two is simple: interest is considered while calculating ROI. And the Kelly criterion follows the probability.

What is Kelly Criterion?
What are the Pros and Cons of Kelly Criterion?
How does the Kelly criterion work?
How do investors use the Kelly criterion?
Mechanism of Kelly Criterion

What is Kelly Criterion?

Generally, the Kelly criterion is a formula that maximizes the expected value of the logarithm of wealth that is equivalent to maximizing the expected long-term growth rate. The idea was derived from an American scientist John L. Kelly, who was a member of a research center at AT&T’s Bells Lab, New Jersey in 1956.

This method is used mostly by gamblers and investors to get double on the investment or bet they have funded. The formula works through a predetermined fraction of assets.

The Kelly criterion method earned recognition in gambling and investment, as people aim to get more returns and save bankroll. So, the Kelly criterion fit the ball in accelerating the earnings.

What are the Pros and Cons of Kelly Criterion?

Pros of Kelly Criterion:

• The main purpose of implementing the Kelly criterion is to estimate the expected value in the future which helps maximize the rate of asset growth.
• There is no plethora of loss of money on the investment, as it will take less money in case of prolonged series of failures.
• Lately, the Kelly criterion is highly dependent on the probability of winning and the probability of loss of the asset value. So, if you have the chance of high returns on the investment, it's a win-win situation for you accordingly.

Cons of Kelly Criterion:

• As said before, The Kelly criterion works with probability whereas if the rate of investment runs positive in the market, you would benefit from its output. Meanwhile, if the asset value faces a bank stake, then it's a loss for you.
• Secondly, people won’t stay in the long-term investment unless it shows propitious promising in the future for the investors.

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How does the Kelly criterion work?

The Kelly criterion is formulated in two fields- Gambling and investment, which is the only place, where a person can win a hefty amount and manage a long-term growth of capital.

The method is all about the comparison of other strategies to identify the asset value. In the olden days, the Kelly criterion was made for gambling, where the participant bets on the coin and expects a high value.

Besides, the Kelly criterion works on investment by enticing participants to pay off more on such investment which gives him flavorful output in the future.

Participants use the Kelly criterion, where the expectation value of a function is given by the sum, over all the possible outcomes, of the probability of each particular outcome multiplied by the value of the function in the event of that particular outcome.

How do investors use the Kelly criterion?

Kelly criterion is used by investors while trading in the stock market to find the percentage of the money they need to allocate to each investment. This is done by using a mathematical formula.

K% = W - [(1-W) / R]

where,

​K%=The Kelly percentage

W=Winning probability

R=Win/loss ratio​

The investors have to access their past 50 to 60 trades from their recent tax returns. Investors have to calculate the value of W - the winning probability. The value can be found by diving into the number of positive resultant returns by the total number of trades that can be both positive and negative. Anything above 0.50 and any number close to 1 is good.

Then R - win/loss ratio is calculated by dividing the average gain on positive trades by the average loss on negative trades. It is good if the number is less than one and the losing trades are small.

Both the W and R values are applied to the Kelly criterion formula and the result is noted. The result percentage indicates the size of the positions that should be taken in the assets in the portfolio. If the resultant percentage is found to be 0.31. Then one should take an estimated 31% position in each of the equities in the portfolio.

It is advised that not more than 20% or 25% be invested in one asset or equity as it increases the financial risk.

The Kelly criterion is known to be used by popular investors like Warren Buffet, Charlie Munger, and Bill Gross.

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Mechanism of Kelly Criterion

Kelly Criterion is a money management principle and can be applied mainly in activities related to gambling and investment. In investment, the formula calculates the percentage of the account that the investor needs to invest. In sports gambling, the formula is mainly applied to maximize the potential returns on wagers and minimize the chances of losing a bankroll entirely.

Let’s take an example on the note of “how do the Kelly criterion formulae apply?” Let’s say probability, the first thing that comes to mind is fifty-fifty chances or a win-loss situation. If you roll a dice, then the chances of getting any number between 1,2,3,4,5, and 6 are unknown. So, take 1,2,3 as 60% possibility whereas 4,5,6 are 40% possibility and vice versa.

For instance; if a company offering a trade of 27.73 per share with an upside range of 37.65 and downside worth of 23.85.

So, out of 100% per share value (27.73)- 70% probability of earning an upside value of 37.65 and 30% of 23.85.

if you calculate the percentage value of upside and downside per share, you will get a 35.77% Gain and 13.99 as a Loss.  

So, now perform the Total Expected Outcome (Probability)= (70% x 35.77) + (30% x [-13.99 LOSS]) = 20.84

now, apply Kelly Criterion formulae;

Total capital planning to allot = 20.84/ 35.77= 58.26%

Therefore, the company plans to invest 58.26% of the capital investment.

Conclusion

Kelly Criterion is one famous method used for a long time both in gambling and investments. Kelly criterion helps in minimizing the loss and focuses on achieving efficient returns through diversification. It is necessary and important that proper judgment based on reliable means should be taken while dealing with capital.

Even though the formula was created by John Kelly of Bell Labs, to analyze long-distance telephone signal noise, the Kelly criterion acts as a reliable model to help gamblers and investors in deciding the size of the position they should take which leads to diversification and efficient and effective money management.

FAQs

What is Kelly Criterion?

Kelly Criterion is a formula proposed by John Kelly used by investors to calculate what percentage of their money they should allocate to each investment.

Which investors use Kelly Criterion?

Popular investors like Warren Buffet and Charlie Munger, along with legendary bond trader Bill Gross.

Who developed the Kelly criterion?

The Kelly Criterion was proposed by John Kelly in the 50's who at that point was working for AT&T's Bell Laboratories.

What is the formula for Kelly criterion?

The Kelly Criterion formula is K% = W - [(1-W) / R]. Here, K% stands for Kelly percentage, W stands for winning probability and R stands for the ratio of winning or losing.

Kelly Criterion is used for?

Kelly criterion is mainly applied in the field of investment and gambling. It is used to determine the amount of money one should bet in a single round.