THE SECRET FORMULA

Edward Thorp is a successful investor, a contemporary of Warren Buffet. He is of almost the same age of Warren Buffet and has been beating the Dow and S&P over several decades since 1960s through his own hedge fund. The brilliance of Warren Buffet is evident as he scaled up his activities from a hedge fund into a listed company and relied on insurance premiums instead of hedge fund limited partners.

 

Edward Thorp is a mathematician by profession and hence relied on mathematical approach to risk and ran a well sought after hedge fund. When Warren Buffet liquidated his hedge fund in 1968/69, he had recommended Thorp to the limited partners who didn’t opt for the shares of Berkshire.  

Edward Thorp’s contribution to the investment area is great and we can learn a lot from his track record and insights.

 
He is an avid follower of Kelly formula for taking positions in the market. By the way, Charles Munger  (Warren Buffet investment partner) also expressed support to this formula.

What is Kelly formula?
 
Let us go back little bit in history.

John Kelly, who came out with the formula in 1956, was Bell Labs scientist. The formula is a corollary to a Bell Lab  application for information theory’s ideas which were developed to facilitate higher information rate for a given channel capacity (of Bell Lab projects). The genius of Kelly understood that the insight of the application is good to solve uncertainty element of gambling or risk taking.

If you have an edge in a probabilistic outcome, Kelly formula would show the exact amount to invest/ risk in order to maximize your capital over the long term.

When applied to stock market, it means the maximum rate of return comes when you know something the market doesn’t or ignores or you can structure a trade or investment where your gains will be more.

The formula is as follows:

Capital to be committed = Pw- (Pl / edge)

Where Pw     = probability of winning

           Pl          = probability of losing

           Edge  = the win ratio i.e. winning amount/ losing amount

For example, if the investment outcome shows a gain of 2000 vs. a loss of 1000, you have an edge in the ratio of 2:1. You assign a 60: 40 probability. The capital you have to invest is 100,000/- . How much you may invest in this deal? Is it full capital? Let us try Kelly’s formula.

= 0.60 – (0.40/2)

= 0.40 or 40% of the capital can be invested

Suppose, after observing some latest developments on the market, you are less confident and revise the probability to 35:65. How much you should invest?

= 0.35 – (0.65/2)

= 0.0250 or 2.5% of the capital can be invested.

Before trying in real life situation, you have to master the formula and understand its limitations as well. If interested, the original 1956 article, “A New Interpretation of Information Rate” by John Kelly is available. Although there are critics to the above formula-  Edward Thorp is a strong supporter. He has penned an article in support “The Kelly Criterion in Blackjack, Sports Betting, and the Stock market’. Edward Thorp is also the author of two successful books related to investment and risk taking.

If interested to know more on the topic/ articles mentioned above, you may please email me at ciby@financialviewsonline.com