Learn The Kelly Criterion For Stock Investment And Money Management

I have written earlier in my blog on managing the personal financial portfolio and asset allocation which I follow personally, you can read it here. But I am no genius, so writing this post to help you understand a very popular stock investment, asset allocation and money management strategy known as “The Kelly Criterion”.

First a word on who is Kelly?

John Kelly was a physicist working with AT&T’s Bell Laboratory. He developed the Kelly Criterion to assist long-distance telephone signal noise issues in AT&T. In 1956, John Kelly published a paper titled A New Interpretation of Information Rate, now available as a book – Bet Smart: The Kelly System for Gambling and Investing. In the paper, he draws an analogy between the outcomes of a gambling game and the transmission of symbols over a communications channel. This is basically an allocation technique also called the Kelly strategy, Kelly formula, or Kelly bet, that we can follow in our investments that you will read in this article. Kelly’s original paper can be found here ( not easy to understand, lots of mathematics there). In the paper, Kelly described a simple and elegant way for investors to strategically allocate capital in the face of uncertainty. This is what is now known as the Kelly Criterion.

There are a lot of writings on how much to diversify money into each stock, how many stocks to invest, for how long etc. This comes under asset diversification and money management. The thumb rule should be – “too much diversification is bad – so stick to a few chosen stocks for the long term”.

Side note: I do have a course on How to Choose Stocks and Invest for Short Term and Long Term profits. You can get the course free if you open a ZERODHA Demat account mapped to me. Click here to register and start the process. Once done I will send the strategy to your email. I have chosen 21 stocks to invest which I will reveal in the course, plus I have also written how to chose stocks yourself for investing. 

In this article, you will learn how the Kelly strategy works and how you can use the formula to help in asset allocation and money management. The Kelly Criterion is a mathematical formula that helps investors and gamblers calculate what percentage of their money they should allocate to each investment or bet.

With time the gamblers too started using The Kelly strategy to maximize their chances to win in horse racing. Today investors, as well as gamblers, use this formula to maximize their profits. They calculate what percentage of their money they should allocate to each investment or bet.

In fact, The Kelly Criterion strategy is used by HNI investors like Berkshire Hathaway‘s Warren Buffett and Charlie Munger, along with legendary bond trader Bill Gross.

Now let me discuss “The Kelly Strategy”. I will have to start with an example to help you understand.

Suppose you are a novice investor, you just opened an account to invest in the share market and ready to invest.

You do not want to risk too much capital to start with. So you search for a good stock, but then you realize that good stocks are costly and so search for a mid or small-cap stock. By chance, you stumble upon a stock priced at 10 (let’s call it ABCD stock) but found that it is a highly volatile stock. It either halves or doubles in value in one month but there is no way to predict the future. Since the amount you want to invest is low you take your chances and invest in that stock. You just buy 100 stocks by paying Rs.1000/-. Not too much risk right?

At the start if each month you can re-balance your portfolio. Re-balancing means you can buy more of the same stock if you have the cash but just a few like 10 stocks or something. By buying 10 stocks your life will not turn to hell. Its a minuscule amount that you can easily invest.

IMP TIP: What is written above is a very important advise. If you want to keep a stock for 10 years and above then make sure to re-balance it every month. Just buy few more do not buy too much in greed. With time you will get the best average price. After 5 years of investing if you need some money and the stock is in good profit you may sell some and take cash out for emergencies.

After a long time. Long time is 10 to 20 years you will need to sell all of the holding of the stock to liquidate and get cash. Nowadays it can be done with the [press of a button.

You will want the stock to give you the max profit.

I have written above that you need to re-balance the stock holding. Now here is where “The Kelly Criterion For Stock Investment And Money Management” comes into place.

Here is your re-balancing strategy:

Imagine this is the first month, means 30 days have passed since you invested. It is time for re-balancing. Since the stock ABCD is highly volatile in 30 days, it can either double or half or may be 10% or more up or down.

Lets assume ABCD stock either doubles or halves in a month. So for each ₹10 invested you get either ₹20 or ₹5 at the end of the month. Note that in real world this may not be possible, but the logic is good for a highly volatile stock.

Here is the average of what you will get at the end of the month: (₹20(double) + ₹5(half))/2 = ₹12.50.

Lets calculate the return:

(2.50/10) * 100 = 25%

That’s an average of 25% monthly return on whatever money you invest in ABCD stock.

This looks great right? So the best approach is to invest whatever you can at the start of the 10-20 years of investment right? No as the stock WILL not double every month. Well this is also not a bad investment idea especially you can find out a fundamentally strong company that will remain fundamentally strong over the next 20 years. Read this article to know how an investment of ₹10,000 became over 800 crores in 30 years.

Assuming someone actually does that in the ABCD stock we are discussing. I mean invest once for 20 years. Lets see the return after 20 years.

Best case: ABCD stock doubles every month. Impossible scenario yet for calculation part the result will be thousand of crores.

Worst case: ABCD stock gets halved every month. Return is less than 1 paisa.

As you can understand, neither the best case nor the worst case are remotely likely. The outcome will be something in between.

IMP TIP: Read the above scenarios again. You either make good money investing or lose it all. Therefore you must invest the money that you can afford to lose in stock markets. This can be 5% of your take home salary. Of course worst case scenario will happen only if you take unnecessary risks like greedy trades. However if you become a conservative trader you will make upwards of 2% a month. This is a great return. My conservative option course will help you learn less risky option strategies.

Coming back to our topic The Kelly Criterion Strategy we have to do some analysis on the outcome.

Here is assuming the outcome of 10-20 years of investment – please note that dividends, bonus shares all are included:

Almost all money wiped out = 35%
10% yearly return = 50%
15% yearly return = 10%
20% yearly return = 3%
21% or more yearly return = 2%

I hope you can guess now, if you invest in 10 such stocks very small amount every month only 3 will wipe out all money nor just give you back what you invested, but 4-5 will give 10% and 2-3 will give stellar returns of more than 15% a year.

All in all you will be in good profit.

Now here is some mathematics.

Assuming Mr. Ashok chooses 10 stocks to invest every month of ₹10 each. He invests ₹1000 in each stock that’s an investment of ₹10k a month. Very much possible in today’s world. If any stock price reaches ₹1000 he will buy just 1 share a month so that he never invests more than ₹10k a month.

Total investment made in 20 years: 10000 * 12 * 20 years = ₹24,00,000.00 (Twenty Four Lakh)

In each stock he invested = 1000 * 12 * 20 = ₹2,40,000.00 (Two Lakh Forty Thousand)

Now the math of the returns:

In 3 stocks he lost 50% of his investment: (2,40,000/2) * 3 = ₹3,60,000.00 (Three Lakh Sixty Thousand Loss)

In 4 stocks he made an average of 10% yearly return.
Final value = 7,59,368.84. Profit = 7,59,368.84 – 2,40,000 = ₹5,19,368.84
Total profit in 4 stocks = 5,19,368.84 * 4 = ₹20,77,475.36 (Twenty Lakh 77,475.36)
(Calculated from this website)

In 3 stocks he made an average of 18% yearly return.
Final value = 1,900,361.23. Profit = 1,900,361.23 – 2,40,000 = ₹16,60,361.23
Total profit in 3 stocks = 16,60,361.23 * 3 = ₹49,81,083.69 (₹ Forty Nine Lakh 39,946.92)

Now lets calculate the FINAL PROFIT:
49,81,083.69 + 20,77,475.36 – 3,60,000.00 = ₹66,98,559.05 (₹ Sixty Six Lakh 98,559.05)

What did you notice?

Even if 50% of the stocks outperform they will skew the average and beat the losses made form the other dud stocks by far over the long term. Note that loses are limited to the amount invested but profits are unlimited. That’s the genius of Kelly – he found that strategy.

So the final question – How to find 10 stocks that may give stellar returns over the long term?

I can help you or at least give you an idea of how to find.

All you have to do is click here and register – the most trusted, honest and No.1 Discount Broker in India. They do not charge any brokerage to buy and sell stocks. However I may get a percentage of the brokerage that is generated by you if you open an account mapped to me.

Contact me after your account is opened I will teach you how to find good stocks to invest for the long term.

Hope this article has helped you to learn something about stock investing. If you have any doubts please ask in the comments section below.

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