Kelly Criterion Trading Strategy : Used by Buffett, Munger, Pabrai
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FYI Some people refer to the Kelly formula as the Kelly Criterion, but it’s the same thing.
Warren Buffet, Charlie Munger and Mohnish Pabrai use the Kelly Criterion as a safe way to guide their decision into the size of the investment they should make. So if it’s good enough for the best investors, it is good enough for us.
Kelly Percentage = probability of winning - (1 - probability of winning)/ winnings as a percent
So let’s enter the information for this game.
K = 0.5 - (1 - 0.5) / 1.5
= 0.167 or 17% of your available balance.
So in this game, it would be wise for your first bet to wager 17 cents.
Because if you lose, you still have bankroll to try again.
Now something that is VERY VERY VERY important. Is this Kelly Formula only works when you have a profitable opportunity.
But our coin flip game gives you 50/50 odds and the win is bigger than the loss. So it’s a profitable game.
So how do we use it for the stock market? Or any investment?
So I’m going to go through the example of Global Cord Blood Corp, which is a Chinese company I have been interested in for some time now.
It’s a good example as the risks are higher than a lot of other stocks.
Right now there are 156 Chinese based companies listed in the US.
So if 1 in 8 companies have fraudulent activities, that would be 12.5%.
But let’s presume it’s higher than that and the fraudulent numbers are at 2010 levels of 35%.
Let’s also assume, that these companies are so fraudulent, that their stock price should be 0.
Even though a lot of fraudulent companies have different degrees of fraud, some minor some major. But let’s assume if the company is fraudulent, we get wiped out.
So far we have our win probability at 65% and our loss probability at 35%.
I think it’s better to be conservative here and say there is a 20% chance of something like this happening.
So now our win percentage is down to 45%, and our total loss probability is 55%.
Now what do we win if the 45% probability event takes place?
But again, let’s be conservative, so I think at a minimum, the win would be that the company reaches the level of the Take over offer on the table. Which is $7.50 per share.
The current share price is $3, so to get to $7.50, it would be a 150% increase.
So let’s put all of this into the Kelly Formula and see what happens.
Kelly Percentage = probability of winning - (1 - probability of winning)/ winnings as a percent
K = 0.45 - (1 - 0.45)/1.5
K = 0.083 or 8%
Let me summarise by saying this.
No investing system is perfect. The Kelly formula will help you allocate funds to opportunities effectively, but it will not pick winning stocks for you.
But when a great opportunity comes along, The Kelly formula will help you take advantage of it. If the odds are in your favor, and the rewards are really high, well you should be aggressive. The Kelly formula will definitely help you be more decisive.
Sometimes you need to go big, but just not so big that you get wiped out and can’t recover.
If you enjoyed the Kelly formula, don’t forget to subscribe and I’ll see you in the next video.
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