The Kelly Criterion
Because global markets rise and fall in cycles, periodically crashing to irrational lows, this throws up wonderful opportunities which allow you to generate significant wealth.
You don’t need to be fully invested at all times, whatever the finance industry might try to tell you (or sell you!).
Instead you can think of your investing as a series of repeated similar bets, patiently picking off great buying opportunities.
The simple knowledge that there are many stock markets and sectors around the world, and that they have their own market cycles, can be your informational edge.
As discussed in earlier posts, when markets are historically cheap, the expected returns are higher, and often much higher.
Of course, the opposite also holds true – when markets are expensive, expected future returns are moderate at best (and often prove to be negative).
It’s not difficult to identify when to invest, by using simple measures such as the CAPE ratio.
Take a look at the difference this has made to returns historically.
Obviously, then, you want to bet on cheaper markets with higher expected returns.
Simple and effective
‘Surely it can’t be that simple?’ you may say.
Well, yes it is, but you must be contrarian and be able to invest in cheaper markets when everyone else has seemingly bailed out.
It’s rarely profitable to invest in what’s comfortable or presently popular.
If you follow the crowd and invest in what everyone else is investing in, you’ll get average returns at best.
As the peak of every market cycle approaches people come up with hopeful reasons why this time will be different, and every time they’re wrong.
Risk, reward, and randomness
As investors, we’re interested in maximising wealth for the long term, so you need to adjust the amount you invest according to how much capital you have available.
You must never risk ruin.
The Kelly model accounts for this by adjusting the size of your bets over time.
You need to make certain you’re around for all those wonderful opportunities that will surely become available in the future!
It’s important to note that the role of the Kelly Optimization model is to maximise your actual expected wealth.
And, as we’ve noted previously, the sequence of returns matters enormously.
What we’re not interested in is theoretical ‘average’ returns, or blindly following any mechanical strategy regardless of market conditions.
The Kelly model maximises the expected geometric growth rate over the long term, although monthly volatility may be higher.
How you ever wondered why so few people retire wealthy?
Look again at the difference in the returns above – and then run the numbers for yourself.
If the Dow index really compounded away at 7.1% then it would have risen from 66.08 points in January 1900 to about 250,000 this year.
Of course it’s done nothing of the sort, yet the talking heads will still insist that ‘the average return is about 8% return per annum’.
Yes, there have been dividends, but also don’t forget the long periods of high inflation.
The slide above partly explains why most people retire with just enough to scrape by, while a handful of investors multiply their way to enormous wealth by buying low and selling high to compound their geometric returns.
Fund managers conveniently don’t mention this (sometimes they just don’t know).
Question the popular narrative: the average returns that people quote are often bogus.
The average temperature in Australia might well be 20 degrees, but this information is worse than useless.
Remember, the Kelly model of investing can be thought of as effectively a series of similar repeated bets, executed only when the odds are in your favour.
Because even a cheap market can get cheaper, it’s important not to over-bet, and to spread your risk using appropriate methods of diversification.
For this reason, many investors choose to use a fractional Kelly strategy to manage risk.
The great investors that have consistently outperformed the market over time, including Buffett, Munger, and others, understand that when the odds are in your favour you increase the size of your bet.
Remember Rule #1: don’t lose money!
And Rule #2 is: see Rule #1.
What information do you need to generate wealth-producing rates of return?
In short, you simply need to be able to recognise when a market is historically cheap, and where the expected returns are high.
If you combine a Kelly model for position sizing with our 8 timeless investment principles then you have a proven strategy for maximising your long-term wealth.
To find out more about our coaching programs see here.
Appendix: for those interested, the equation below shows how the bet size can be adjusted according to the size of your portfolio.