Investing- Size does matter

Investor who wants to beat market must have EDGE and view on how much money to invest on that stock. i.e optimum amt of money to maximize the geometric mean.

One important thing I have disclose by my own learnt lesson that “ you are unlikely to get an edge out of what you see in news/tv.” . The stock market more effient than the many small investor think. The way to achieve edge is path shown by Charlie Munger, Multidisciplinary thinking which I had discussed earlier.

Today we will discuss about How much to invest (Bet Size) when you  have EDGE.

Always Geometric Mean (GM) less the arithmetic mean (AM) so geometric mean is conservative way of valuing the risky proposition.

Warren Buffet repeatedly stressed the importance of  patience as the most important trait investor has to posses in investing , which means that you should invest only when you have edge and Jhon Kelly tell how much to bet .

Kelly criterion maximizes the median wealth and The Kelly system leads to a distribution of wealth (among scenarios or parallel universes) also shuns the tiniest risk of losing everything, for unlikely contingencies must come to pass in the long run. The Kelly criterion has, “automatically built in… air-tight survival motive.”

Kelly  formula  gives fraction ( f ) bank roll to invest.

f =Edge/odds                       where: edge: Amt you will win

                                                                           odds : profit if you will win

=(P*W-q)/W                   P= probability of winning ,   q= 1-p = probability of losing

                                                  W=winning amt per Rs invested

                                                                                                                                                                       

Example:  In coin tossing on one Rs bet, Heads u get Rs 2, tails you loose. So fraction of your bankroll  to bet for maximise  GM is (p=1/2,q=1/2,W=2)  25%.                                                                                                     

f=( ½*2-1/2)/2=25%

Same can be applied to buying stocks to maximise your portfolio return.

No other money management system has a higher geometric mean than the Kelly system does.Another good feature of the Kelly criterion is that it maximizes the median wealth.

Kelly system cannot do is engineer luck. It is possible to be unlucky when using the Kelly system, to end up with less than the median. When you do, you may be worse off than you would have been with another system.

The ever-expanding web of possibilities is like that interpretation of quantum theory where every chance event splits the world into parallel universes. By the fourth toss, there are 16 distinct parallel universes, corresponding to every possible sequence of heads and tails

In an infinite series of serial Kelly bets, the chance of your bankroll ever dipping down to half its original size is…½. A similar rule holds for any fraction 1/n. The chance of ever dipping to 1/3 your original bankroll is 1/3. The chance of being reduced to 1 percent of your bankroll is 1 percent.

The good news is that the chance of ever being reduced to zero is zero. Because you never go broke, you can always recover from losses.

The bad news is that no matter how rich you get, you run the risk of serious dips. The 1/n rule applies at any stage in the betting.

A fractional Kelly bet doesn’t sacrifice much return. In case of error, it is less likely to push the bettor into insane territory.

For true long-term investors, the Kelly criterion is the boundary between aggressive and insane risk-taking. Like most boundaries, it is an invisible line