Friday, June 1, 2018

More on the Kelly Formula...

From The Warren Buffett Portfolio:
Because the risk of overbetting far outweighs the penalties of underbetting, investors particularly those who are just beginning to use a focus investment strategy—should use fractional Kelly bets. Unfortunately, minimizing your bets also minimizes your potential gain. However, because the relationship in the Kelly model is parabolic, the penalty for underbetting is not severe. A half-Kelly, which reduces the amount of the bet by 50 percent, reduces the potential growth rate by only 25 percent. 
This seems a good place to summarize: 
1. To receive the benefit of the Kelly model, you must first be willing to think about buying stocks in terms of probabilities. 
2. You must be willing to play the game long enough to achieve its rewards. 
3. You must avoid using leverage, with its unfortunate consequence. 
4. You should demand a margin of safety with each bet you make. 
"The Kelly system is for people who simply want to compound their capital and see it grow to very large numbers over time," says Ed Thorp. "If you have a lot of time and a lot of patience, then it's the right function for you."

Related previous posts:

Generalizing the Kelly Criterion

A quick diversification thought...

A few comments on the Berkshire Hathaway letter to shareholders

Warren Buffett and Charlie Munger on portfolio concentration, and having the right temperament for it