The Joys of Compounding by Gautam Baid
The Dynamic Art Of Portfolio Management
The primary goal of any investment operation should always be to put together a portfolio that is best suited to meet the individual's personal life goals and financial needs. The only metric that any investor should be concerned with is whether they are on track to meet the objectives they set for their portfolio in the first place.
Investing is all about expectations, and the outcomes are influenced by changes in expectations, which cause changes in stock prices. As a result, the ability to correctly read market expectations and anticipate revisions to those expectations serves as the foundation for superior returns. To do so successfully, an investor must have "variant perception," that is, a well-founded view that differs significantly from the market consensus.
The Kelly Criterion
The Kelly criterion, developed by John L. Kelly and popularised by Ed Thorp's practical success, is a formula used to determine the optimal bet size for a given set of probabilities and payoffs. Although the formula can be expressed in a variety of ways, the following expanded version was published in Thorp's interview in the book-‘Hedge Fund Market Wizards’:
F = Kelly criterion fraction of capital to bet,
PW = probability of winning the bet,
PL = probability of losing the bet,
$W = dollars won if bet is won, and
$L = dollars lost if bet is lost.
The Kelly criterion bet size will maximise capital in the long run if an individual knows the odds and payouts of a given bet with precision. One major issue is that people don't get precise odds, and they only get a reasonable picture of the payout in the rare special situation or arbitrage. Another difficulty is that, when using Kelly, the long run is based on the number of events rather than on a time frame. An investor who bets infrequently will find it difficult to make enough investments to reap the full long-term benefits of using Kelly.
Another significant limitation is that people tend to underestimate the importance of infrequent, high-impact events, also known as Taleb's black swans. When investors look to apply the Kelly criterion, the probability and magnitude of negative black swans may not be given the necessary consideration, and thus the formula, when applied by the human mind, may tend to overestimate “F”, and constant overestimation leads to disaster.
So, anything greater than the optimal bet size will result in a total loss sooner or later.
Despite the practical difficulties and impediments in applying the Kelly criterion to real-world investing, the underlying logic behind it is extremely useful as a way to consider whether to establish a position in a given situation and, if so, what proportion of capital should be invested in that position.
Individual allocations in the author's portfolio are sized based on his assessment of potential risk, with the largest holdings having the lowest likelihood of permanent capital loss combined with above-average return potential. He starts new positions with a minimum weighting of 5% and then averages up if management outperforms my expectations. Individual position sizing is critical because of the impact it has on overall portfolio performance and mental peace of mind. If an individual position becomes an uncomfortably large percentage of his portfolio value, he sells down to his "sleeping point."
So, always put more weight into companies that have a long track record of success, solid growth prospects, and disciplined capital allocators.