Unexpectedly Intriguing!
25 April 2007

Diversification can be a powerful tool for an investor seeking minimizing the risks associated with their investment choices. But it also leads to new questions, such as "how should I diversify my stock portfolio" and "how much should I invest in each of my individual stocks?"

While the answer to the first question may be as unique as each individual investor, the answer to the second might be found in the Kelly Criterion, a method that was originally developed in the 1950's by John Kelly, who worked at AT&T's Bell Laboratory, to deal with signal noise issues in long distance telephone service.

That the method might also be effective in reducing gambling losses and maximizing winnings over the long term became apparent to both Kelly and professional gamblers. For his part, Kelly described his method in 1956 in A New Interpretation of Information Rate.

Beyond the telecommunications and gambling industries, the Kelly Criterion has also proven to be useful for investors seeking to minimize the downside risk of losses in their investing portfolios while also increasing their returns over time. That's why our latest tool does the math behind the Kelly Criterion for working out how big your individual stock investments should be!

Here are the things you need to know or estimate before using the tool:

  1. How many winning trades have you had? In other words, if you go back over your investing track record, how many of your individual investment trades that you've bought and sold provided positive gains?

  2. How many individual investment trades have you made? This will be used to find your overall probability of making a winning trade based upon your historical track record. The tool assumes that you'll continue to have the same luck as you have had in the past in picking winning investments. You don't necessarily have to go all the way back to the beginning of your investing "career", but you do want to cover at least 50-60 trades (or as much as possible.)

  3. What is your average gain on a winning investment? When you've come out ahead in the past, what's the average amount you've gained?

  4. What is your average loss on a losing investment? If you've racked up any losses, here's where you account for the average amount you've lost for each of your losing investments.

And that's it! Enter the indicated data and our tool below will find out how much you should place in each of your individual investments using the Kelly Criterion:

Investing Track Record Data
Input Data Values
Number of Winning Trades
Total Number of Trades
Average Gain on a Winning Trade
Average Loss on a Losing Trade

Kelly Criterion Results
Calculated Results Values
Probability of Making a Winning Trade (%)
Ratio of Win/Loss Amounts (%)
Kelly Criterion (%)

The Kelly Criterion percentage given above is the percentage of the entire value of your portfolio that you should invest in any one stock within your portfolio.

Investopedia's Justin Kuepper offers this additional advice:

The system does require some common sense, however. One rule to keep in mind, regardless of what the Kelly percentage may tell you, is to never commit more than 20-25% of your capital to one equity. Allocating any more than this is carries far more risk than most people should be taking.

And he notes some other things you should know (the chart referred to is available through the link above):

No money management system is perfect. This system will help you to diversify your portfolio efficiently, but there are many things it can't do. It can't pick winning stocks for you, make sure you continue to trade consistently or predict sudden market crashes (although it can lighten the blow).

Also, there is always a certain amount of "luck" or randomness in the markets, which can alter your returns. Consider again the chart we looked at above. See how the best person received a 140% return, the worst got less than 40%. Both traders used the same system, but randomness and volatility can cause temporary swings in account value.

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