Said another way, for consistent outperformance, it's not good enough just to identify favorable investment opportunities, but you must also identify how much of your assets to allocate to the take full advantage of the opportunity. In other words, how much to weight your portfolio with that particular holding.
Generally, amateur investors like myself who hold focused portfolios, have some instinctual understanding that positions must be overweighted to outperform the index. We may reference general comments and schools of thought, like knowing that superinvestor Warren Buffett once held over 50% of his net worth in a single stock (GEICO), and also once invested more than 25% of his public stock holdings in American Express to help us with our portfolio weightings.
But the question remains of how much, scientifically, to allocate to a particularly favorable opportunity in our own portfolios. The Kelly Criterion (link also provides an example of how to use it, based on your own historical trading success and patterns) provides one such answer. I'm going to borrow a different and simpler example (using the Kelly Criterion) to illustrate the point.
Suppose, on a coin toss, you were to receive $2 for every time the coin turned up heads, but had to pay $1 for every time it turned up tails. How much should you allocate to maximize winnings, while ensuring that a few coin tosses don't send you to ruin? The Kelly Criterion says you can effectively maximize winnings by using this formula:
- Edge/Odds = Allocation percentage (the answer we're seeking)
The odds are calculated by knowing how often this the event will turn out favorably. Since we know the coin has only two sides, and one sides value is double the other, then we know that the odds are 2:1 (ie. $2/$1). So the odds figure is $2.
We then divide one figure (edge, $0.50), by the other (odds, $2), to arrive at the suggested allocation for the portfolio, or "the bet". In this instance, $0.50/$2.00 = 25%. This suggests we should allocate 25% of our portfolio in each particular round, to this particular "bet" (assuming all odds and edge factors remain the same).
This system has several noteworthy features:
- It's theoretically impossible to go bankrupt, given that money is theoretically infinitely divisible (down to the 1 cent level anyway);
- The system produces the maximum return in the shortest period of time, on average;
- The returns are very noticeable and lumpy - for example, if your first three coin tosses were negative, and you started with a $10 bankroll, you'd be down to $4.22.
Hat tip to Abnormal Returns for sending us out there ...
The Confused Capitalist