By Andy Snyder Editor’s Note: A version of this piece originally ran in Andy Snyder’s free e-letter, Manward Digest. You can go here to automatically subscribe if you haven’t already.
It’s one of the most common questions we get. Readers often write us and ask how much money they should devote to each trade.
Below is the Vegas secret that I share with my Manward Digest readers.
To be clear, we have a moral issue with gambling. After all, one of our core beliefs is that wealth leads to Liberty. Therefore gambling leads to slavery.
It’s a dangerous game.
We don’t partake.
Even so, we’re fascinated by the numbers behind it all. They’ve certainly guided our investment philosophy.
One man – an infamous Vegas insider – has taught us a lot.
Edward Thorp is the math genius and professional gambler who turned the odds on Vegas and then revolutionized Wall Street.
He’s a Manward kind of man – a thinker.
Even though he spent years in the blackjack game, Thorp would argue he’s not a gambler. He’s an investor. He put down his chips only when the odds of winning were better than the odds of losing.
Thorp won a lot.
He won so much, he was kicked out of most casinos.
When Thorp put on disguises and taught others to do his work for him, Vegas changed the rules. Then, with the math no longer in his favor, he took his skills to Wall Street.
It was a move that benefited us all… especially when it comes to managing our risk.
Revealing a Secret
You see, there’s a secret of the Vegas blackjack tables that aptly applies to investing.
Thorp used it to know exactly how much to bet on each hand so he’d be sure to end up a winner.
But it worked equally well on Wall Street as a tool to determine how much to invest in each position. It made Thorp a near billionaire – worth some $800 million today.
He taught it to Bill Gross (who Thorp mentored) and Warren Buffett. From what we hear, it treated them well, too.
All three still use this vital risk-management strategy.
It’s a formula called the Kelly criterion, and it spits out the percentage of your portfolio that you should devote to one trade.
It looks like this: Kelly % = W – [(1 – W) / R].
We need just two important pieces of data to crunch the numbers.
First, we need our win probability – the “W” in the equation above. That’s the historic proportion of trades we’ve made that have led to a gain.
It’s simple to calculate.
First, we gather the results of at least our last 25 to 50 trades – not the dollars made or the percentages lost, just whether they were gains or losses.
Simply divide the number of positive trades by the total number of trades.
For example, if 35 out of 50 trades were wins, our “W” number would be 0.7.
From there… we need the “R.” That’s our win-loss ratio.
To get it, simply divide the average dollars gained on each winning trade by the average loss on each …read more
Source:: Investment You
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