Financial advisors often preach the mantra “diversify, diversify, diversify”. Investors should also put specific amounts into different sectors or stocks. What is the source of all this? Money management systems, including the Kelly Criterion, are behind this.
Following a set of rules, this system refers to Kelly Formula, Kelly Strategy, and Kelly Bet. Here is a detailed description of the Kelly Criterion and how investors can use it to improve their asset allocation and money management.
Kelly criterion basics
There are two primary components to the Kelly Criterion. Optimal outcomes, or winning trades, are the first of these. Additionally, the total win-loss ratio measures the ratio of winnings to losses.
These two factors are input into the Kelly Criterion equation to determine the optimal trade size, despite the trend.
The equation is as follows:
K%=W− (1−W)/R
Where:
K% = The Kelly percentage
W = Winning Probability
R = Win/loss ratio
Kelly Percentage is the output of the equation, which has many uses beyond portfolio management. Investors use this percentage to determine how much to allocate to each stock or market sector, while gamblers optimize their bet size.
Interpreting the Kelly percentage
You will receive a number less than one, representing the size of the position you should be entering. You can convert the number returned into a percentage by multiplying it by 100. To get 4%, multiply 0.04 by 100 using the Kelly equation.
This means that each stock in your portfolio should be worth 4% of your portfolio. Your past performance determines how much diversification you should make based on the system.
It would help if you used common sense when using the Kelly Percentage. It is always advisable not to risk more than 20% of the available capital on a single stock, regardless of how big the Kelly Percentage tells you to enter a position. Due to a lack of diversification, this increases your portfolio’s risk.
Is the Kelly criterion effective?
It should be possible to test the Kelly Criterion’s profitability in the long run since it is purely mathematical. Despite this, many people wonder how an equation designed initially for telephones can help invest.
By simulating the growth of your account using the Kelly Criterion mathematics, you will find that the Kelly Percentage is an effective system when backtesting. To be effective when investing, the Kelly Percentage system must correctly calculate and enter the two variables, and the investor must maintain the same performance in future trades.
Why doesn’t everyone make money with the Kelly criterion?
Kelly Criterion and Percentage can help maintain a diverse portfolio, but they are far from perfect. Diversifying your portfolio is one thing, but there are several other things it cannot do.
For instance, the algorithm will not be able to pick a black swan event that causes a sudden market crash. The returns of any system are always affected by randomness in markets.
Bottom line
Protecting your account with money management is possible, but you can’t guarantee great returns. You can’t even be sure you won’t suffer losses occasionally. With its ability to diversify your portfolio efficiently, it can help minimize losses when they occur as well as maximize your winnings. A money management strategy like the Kelly Criterion might be what you’re looking for if you also seek diversification.
