Only if it’s employed in defining risk.
Intertemporal portfolio choice is a fancy way to describe the repeated allocation of investable assets to a variety of investments during regular intervals over some period of time. The Kelly Criterion (Kelly) is a formula developed in 1956 by Bell Labs physicist, John L. Kelly, Jr., that was adapted by gamblers to determine the optimal size for a series of bets. When you combine these two things, you end up with an investment strategy that can optimize returns and help with risk management (Warren Buffett and Bill Gross are thought to use Kelly).
Edward O. Thorpe, a professor of mathematics, avid gambler and early hedge fund manager, proved the practical use of the Kelly formula in gambling and investing. Thorpe demonstrated that, if, over a long period of time an observed fraction of successful bets or investments is equal to the probability that any given bet or investment will be successful, Kelly will do better than most other strategies.
But what is Kelly and how does it work? Let’s take a look.
First, let’s start with the formula itself. The two basic components to Kelly are win probability and win/loss ratio. Win probability (W) is the probability that any given trade or wager you make will return a positive amount. Win/loss ratio (R) is the total positive trade or wager amounts divided by the total negative trade or wager amounts. Therefore, the amount you should invest (Kelly percentage) or wager can be expressed as follows:
Kelly percentage = W–[(1–W)/R]
The idea of the formula is to tell investors what percentage of their total capital they should risk on each investment (even as a trader, you need to consider how much to invest in your best ideas). But to calculate the ideal percentage of your portfolio to put at risk, you need to know three things: (1) What percentage of your trades are expected to win, (2) The expected return from a winning trade, and (3) The ratio of winning trades to losing trades. Determine these three variables and you’ll be able to employ Kelly to help you manage investment risk.
NOTE: One of the conventional alternatives to Kelly is something called expected utility theory, where utility refers to the subjective value an individual places on an investment based on their expectation for the value of the investment’s return. Expected utility theory holds that the amount you put at risk on an investment should be sized to maximize the expected utility of the outcome (Kelly also maximizes expected utility).
I understand that some traders (you know who you are) encourage using a so called “half-Kelly” strategy when investing. By risking only a fraction of the amount indicated by Kelly, you can help reduce volatility and protect against having your trading account shrink too quickly. As a long-term investor, we would consider Kelly to be a tool for limiting risk and protecting against downside movement in our portfolios.
NOTE: John Kelly is equally well known in film as he is in science circles. In 1962, he synthesized speech—actually the song Daisy Bell—using an IBM 7090 computer and became the inspiration for the HAL 9000, Arthur C. Clarke’s talking computer in his novel and screenplay 2001: A Space Odyssey (HAL was ultimately put to sleep by astronaut, Dave Bowman, while singing the same song).
Something else to consider when using Kelly is that it assumes investments in various securities are uncorrelated. While this may be true for some securities, many are correlated and returns on those investments could be negatively affected by major events such as a global depression or major geo-political event (think Ukraine). This is precisely why our portfolios are allocated across geographic regions, asset classes and industry sectors, among others.
Despite Kelly’s promise of producing better returns than other strategies over the long-term, some economists have argued against it because any individual’s specific investing goals aren’t likely to be based on pure growth alone. Perhaps the greatest value that Kelly brings to the investing table is that it demonstrates that even with a great investment, you should only allocate a small portion of your portfolio to it.
In any case, we view Kelly as one tool among many that can help limit risk in our client portfolios.
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David L. Blain, CFA, is president and chief investment officer of BlueSky Wealth Advisors, LLC, an independent registered investment advisor (RIA) doing business as D. L. Blain & Co. in New Bern, North Carolina and Pleasanton Financial Advisors in Pleasanton, California. You can contact David at davidblain@blueskywa.com.
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