Winning systematically with Fortune’s formula

When timing is everything

When Ed Thorp, the famous billionaire money manager, wanted to test his gambling theory of how to beat the dealer, he started out by card counting at the casinos.

In those days casinos only used a 52-card deck, and when the deck was exhausted the house shuffled and started again.

This allowed Thorp and his partner Claude Shannon to understand that if they knew which cards were already ‘dead’ then the odds on the current hand they were dealt would change.

If all four Aces were already out of the pack, for example, then there was no point calculating the odds of a win based on the appearance of another Ace.

Thus the probability of success was slightly altered. 

Playing the probabilities

A simple example: let’s say you’re playing Blackjack, and you’re dealt a King, and so to get 21 or Blackjack, you need an Ace.

Now imagine it’s the first hand of a fresh deck and so there are 51 cards left (52 minus your King) and so there are 4 Aces in 51 cards.

The probability of drawing an Ace is low.

Now imagine the same hand but it comes nearer the end of the deck, and you know that there are still 4 Aces among the 10 remaining cards.

This increases the probability of drawing an Ace and thus winning the hand.

Thorp understood that in these cases where the probability was higher, it was profitable to bet a larger amount.

How much to bet, though?

The Kelly Criterion

Thorp went on to help create and modify what is now often known as the Kelly Criterion.

Put simply, when you know as an investor the odds are heavily in your favour (a bit like card counting) then you should bet more accordingly (but not so aggressively that you damage your account!).

It doesn’t mean you will win every time, but Kelly and Thorp developed a mathematical formula which demonstrated that if you bet according to the your odds (or probability of winning) then your wealth would end up far in front…and by a greater and greater amount over time.

Source: Poundstone

Why is this important?

Because if you think of your capital as a series of bets, and bet only when the odds in your favour – with appropriate position sizing – your wealth in real terms will accelerate much faster than if you blindly bet the same amount regardless of the odds.

Aiming for each and every dollar invested to work harder is a key reason Buffett has generated such enormous wealth over the decades.

Buffett famously invested 40% of his partnership’s capital in American Express in 1963 after its stock had halved during the ‘Salad Oil’ scandal.

Buffett doesn’t remain fully invested at all times, and he doesn’t bet the same amount each time he invests, which is one of the ‘secrets’ to his enormous wealth.

Unfair advantage

In many gambling situations, such as over a long series of Blackjack hands and only betting when the odds were in your favour (generally better than 50/50), you would, on average, succeed in winning more than losing.

Once the casinos wised up to what Shannon and Thorp were up to they created larger decks to make card counting harder. 

Why were the casinos forced to respond?

Because card counting worked by tilting the odds in the gambler’s favour.

Not just once, but systematically. 

Card counting is banned because it gives the gambler an ‘unfair’ advantage. 

It worked because you could use updated knowledge (the ‘new’ number of cards left in the deck to calculate a new probability of success after every hand) to connect the present to the past.

As with card counting, what has happened in the past affects your current and future prospects in stock markets.

Know your history!

Fortune’s formula

After making some money, Thorp sought other fields of gambling where he could test out his theories.

He developed a mathematical formula and a way to wager using knowledge and probabilities to determine a rate of success.

Thorp developed what is now often known as the Kelly Criterion or ‘Fortune’s formula’.

After a few years of winning and developing the formula further, he came to the stock market, and was tremendously successful as a hedge fund investor, obliterating the index return.

Thorp was able to compound his wealth dramatically faster than the index, by using the Kelly Criterion.

Back to card counting

Gamblers counted cards because they realised that the outcome of previous hands influences your probability of success in the current hand.

Imagine being dealt a hand with a high probability of success. 

If you don’t know what cards are already out of the deck through previous hands you can’t really calculate the odds of drawing a card you want.

However if you’ve been card counting and realise the odds are in your favour then you should place a larger bet.

Why bet a larger amount on this particular hand? 

Because you know when there are 10s, Jacks, Queens, and Kings left in the remaining cards and when the probability of a win is higher.

But that’s looking at the odds in isolation…

Thinking in 10-year timeframes

Investing doesn’t quite present the same dynamic.

You must account carefully for what has happened previously, a bit like listening to the echoes from the Big Bang.

Benoît Mandelbrot showed that stocks have a long memory, and in turn that markets are not always efficient (see Long Term Dependence, and the Hurst exponent).

If you’re an investor seeking favourable bets then you need to look at the expected returns given what has gone on in the past.

10 years of history is a somewhat subjective figure, but it does have an accord with the business cycle, and so Ben Graham and later Robert Shiller invented the CAPE ratio to account for the previous ‘echo’, and the influence it has on future returns.

So investing now is not quite the same as playing the current hand and ignoring the cards that are no dead and no longer available.

What’s happened in the past significantly influences the present – like echoes of the Big Bang it fades, of course, the longer it goes on, but still it pays a key influence.

3 key rules

If investors in US stocks have made a wonderful 400% of gains since 2009, how long will it be before they start living like they have made 400% and cash in their gains, driving prices lower?

You’d be surprised at how alike we are in our behaviour.

As Robert Shiller stated: ‘the folks who are responsible for the bull market don’t realise they are the same folks that cause the bear market’. 

There are 3 important takeaways here:

  1. Be patient – you can’t and won’t win every hand. But there will be opportunities when the odds are heavily in your favour. As Buffett is fond of saying – you don’t have to swing at every pitch;
  2. Bet accordingly – Following rule #1 above means that when the odds do come in your favour then you should bet accordingly. This is why we like using the CAPE ratio, because it tells us when the odds have swung in our favour; and
  3. It does mean that there will be hands where we miss out on a ‘win’ – but still we always think in probabilities.

Probability in investing

There are two fields in probability. 

Some forms of gambling are games where the probability and the odds can be calculated – like cards, horse racing, and lotto, for example.

But investing is a little different.

It’s more to do with uncertainty – you don’t know with any degree of certainty what the payoff will be if you outlay a bet today. 

Bayesian probability

When investing you must update your knowledge and calculate the ‘new’ odds given what has happened previously.

The CAPE ratio gives us a good reading on what to expect because it uses a smoothed 10-year timeframe (you can use others if you wish, but the 10-year has a good correlation with actual investment returns).

But what else you can do to improve your chances of a positive return, such as when card counting?

Look at the situation you are currently faced with and see what has happened in the past.

In investing we know that history won’t repeat, but it does rhyme.

We argue that investing in stock markets is far more favourable given that you can’t easily lose your entire stake on one hand as you can in a card game.

Cards are more independent in the sense that each hand has only a small influence on the odds for the next hand.

We know stock markets around the world rise and fall, however, and so we can look at history (our informational advantage) and determine that they don’t all go to zero (losing every hand).

Therefore you can simply adjust your allocation to ensure that you survive to play the strong Aces hand each time it comes up.

And we know from history that the bigger opportunities will come up, thanks to the patterns of stock market behaviour (market cycles and mean reversion).

At the time of writing we believe the odds are not very favourable in many developed markets.

Buffett, for example, is holding US$128 billion in cash at the moment – a huge percentage share of his capital – and that tells you he’s waiting patiently for the fat pitch.

He wants to make his money work harder.

It’s Fortune’s formula.

To find out more about our coaching programs see here.

Value investing for income (NOT speculating)

Investing for income

Many global stock markets have moved into the rampant speculation phase of the cycle, whereby nearly all of the focus and talk is about speculating for capital growth.

It will end nastily, as it always does.

But how does one invest for income in the meantime, while patiently waiting for sanity to return to global prices?

Today, a brief look at some of the recent investments we’ve made in line with our 8 timeless investment principles.

Of course, these are not recommendations or advice, because individual circumstances differ; they’re merely examples to demonstrate a few of our thought processes.

Contrarian investing

At the time of writing the dividend yield on the S&P 500 is close to a record low at an appalling 1.7%, which means that investing for income in the US is very difficult.

Speculation is rife.

To get better results than average, you have to do something different from the herd, so let’s take a look at how that might be done.

Start with our timeless principles of market cycles and mean reversion, and buying low.

A starting point, for example, might be to look at the sectors that have been out of favour.

For those with no ethical filter or boundaries, you might start with the hated tobacco stocks such as Imperial Brands or British American Tobacco…however, these are off limits for many of us!

Energy has also been amongst the worst performing US sectors for 3 years in a row (and for 5 years out of the past 6), while tech has been soaring.

This is not without reason, as the ESG juggernaut gathers momentum, and fundies scramble towards perceived ‘ethical’ investments.

After a relatively barren run since 2010, energy is one such place to begin looking for value (even still, none of the S&P 500 sectors is actually cheap at the present time).

Within the energy sector, oil and petroleum stocks have been unloved, including mature ‘supermajors’..

Managing the risk hierarchy

Now, remember the risk hierarchy.

If you’re concerned about company-specific risk, it may be safer for you to consider a diversified ETF, instead of individual stocks.

If you are going to accept company-specific risk then ideally we like to look for companies that:

-are well established

-have reasonably low and manageable debt

-have a long track record of strong revenues, earnings, and dividends

-are large, systemic type companies

Cycles repeat

To recap, these are not recommendations, but brief insights into workable ways to invest safely for income, at a stage in the cycle when most people are nervously speculating on a bit of further price growth.

If you’re not comfortable taking on company-specific risk then you don’t need to; you can easily invest in country or sector ETFs instead, for example.

To get better than average results and generate wealth-producing rates of return, you need to jettison the idea of benchmarking yourself against the 12-month returns from any given index.

Such calendar-driven results are meaningless, unless you only have a 1-year timeframe for generating wealth (which you don’t).

See the big picture and remember Rule #1: don’t lose money.

That’s how you become wealthy: by not losing money on expensive investments.

Remember, in cheap markets, you can hoist the mainsail and let the tailwind carry you along.

When markets are historically expensive, you need to protect your capital, and when there’s a headwind this means you’ll need to work a bit harder to generate steady returns.

To find out more about our coaching programs see here.

Separating the signal from the noise (speculating versus investing)

Signal versus noise

We’re usually reticent to provide running stock market commentary – it’s a fool’s errand, and mostly it’s just noise anyway.

However, we do believe investors should be wary of the current market signal.

Ben Graham famously outlined the difference between investing and speculating thus:

Graham didn’t rule out speculating altogether, provided there was some logic behind it.

Unfortunately we’re not seeing much logic at the moment!

Managing exposure

Contrary to how many folks interpret Graham, he spoke extensively about stock market aggregates, what a sensible valuation for the market looked like, and whether it was a good time to invest (see The Rediscovered Benjamin Graham by Janet Lowe).

Both Graham and later John Templeton advocated adjusting your exposure to stocks as markets become too expensive.

They did this by noting what was a reasonable approximation of ‘value’ given the future stream of cashflows (dividends) to investors. 

So low market valuations and prices generally lead to future high expected returns, and vice versa.

This is what the CAPE ratio shows in many developed markets today – low expected returns.

But, as we often say, it’s not a short-term market timing tool. 

Long term focus

Investors are increasingly focused on chasing the capital gains, with much talk about whether the market will go higher, what the 2020 year-end price will be, expected 12-month returns, and so on.

These one-year projections are pure speculation based upon momentum and recency bias.

They add zero value in terms of helping to build your long term wealth.

The CAPE ratio and Graham’s use of earnings yield do a much better job for the investor (not the speculator), as we’re interested in maximising wealth over the long term, not cashing in tomorrow or next week.

It’s anyone’s guess where the market finishes next week or next year, and as Howard Marks pointed out in his most recent memo, Thinking in Bets, don’t confuse skill with luck.

Just because you make a few bucks doesn’t mean you’re a genius.

It’s the process that counts and its why we focus on our timeless investment principles, not only strategy and tactics. 

Managing risk

This leads us to today and our concern for investors, especially those who are young and haven’t yet experienced a serious market decline.

The financial industry operates on selling investment products and generating fees – we don’t criticise that, but simply note where their motivations lie.

Your dollars are their fees and income, so don’t ask the barber if you need a haircut!

What we are critical of is the constant refrain of the finance industry that you must be fully invested at all times, or else this will somehow be detrimental to your returns.

It’s a fallacy – see again our posts on the sequence of returns and geometric averages.

Even asking the simple question ‘what are the expected returns?’ should lead you to the straightforward conclusion that there are both good and bad times to be fully invested.

Please note, we’re not saying it’s all or nothing; it’s more nuanced than that.

Long term versus short term

Many industry folks rightly highlight the importance of dividends as a large part of the success of a portfolio over the long term.

But it’s also important to recognise the relationship between price and value.

As Buffett said, price is what you pay, and value is what you get.

Here’s the maths.

If you pay a dollar for a stock paying a 5 cent annual dividend then the dividend yield is 5%.

If you were to pay 50 cents for the same stock (great!) then the yield is much higher at 10%.

But if you do something silly and pay 3 dollars for that same stock, then the yield is woeful at just 1.7%.

Of course, you do want the dividends to be increasing over time, not just to be chasing a high percentage yield for its own sake.

If you pay too much for the stock then not only is the dividend yield equivalently lower, the risk of a capital drawdown is higher.

Too many folks are flatly ignoring this and are speculating based on the promised future capital gain.

In our experience, overpaying is the cardinal sin and leads to lower future returns.

We adjust Buffett’s saying to ‘the higher the price you pay, the less value you get.

Investing when the market is high leads to lower dividend income, and a potentially large capital drawdown.

We know this because that is simply how markets operate.

It’s not different this time

There’s no ‘it’s different this time’ – it never is, and this time won’t be either.

At the moment almost all of the markets talk is about capital gains rather than income, and not enough attention is being paid to risk.

According to the most reliable market valuations the S&P 500 is at a level never previously sustained (the CAPE ratio now sits above 31.5) and the dividend yield is atrocious at about 1.7% (not relatively, but historically).

We have available figures going back to 1871, and the dividend yield has actually been lower once before, from 1997 forth during the infamous tech bubble.

With a yield of 1.7%, real returns can only be achieved by speculating on capital growth.

You’re missing nothing by not investing at these prices, unless it’s ‘different this time’.

Ben Graham lamented those periods when investors shifted from a focus on earnings (income and investing) to expansion (capital gains and speculation), and this is exactly what’s been going on recently.

Like property flipping, speculation can be lucrative, but it’s also very high risk if you get caught in a drawdown with low liquidity and high volatility.

The low yield is a warning sign of capital losses to come, backed up by the fact that the long-term CAPE average ratio for the US in 16.7 (while the long-term median is 15.8).

The CAPE ratio has exceeded 30 twice before: on Black Tuesday in 1929 (the Wall St. Crash and Great Depression), and in 1999 (the tech wreck).

The market’s dividend yield is well below it’s long term average and so this should be a warning sign to be careful about capital losses, since you are potentially paying too much for very little return.

And the risk of a capital loss is high given what we know about the correlation between long term valuation indicators such as the CAPE ratio and future returns. 

In Australia, banks and REITS are fairly expensive, but industrials are a nascent speculative bubble.

Remember that global markets are now more correlated – if the largest market goes down, we all go down.

Don’t pay too much

Think about the following paragraph.

If dividends are important to your long term returns, then the low yields are a warning sign, and the exposure to expensive equities should be reduced until better opportunities come around.

Think about it.

If dividends are important to your future returns, then you shouldn’t pay too much for those precious income streams.

The level of dividends tells you much of what you need to know about the market level and valuation.

And it’s not a pretty sight. 

Those saying ‘well, yes, but there’s no alternative because bonds are worse’ fail to recognise that investing isn’t a game of moving to where the action is.

Sure, the returns on cash and bonds may be low, but investing also isn’t a game of baseball, and you don’t have to swing at every pitch.

Collecting nickels in front of steamrollers

Besides, there are plenty of opportunities for those that seek out steady returns, instead of wanting to boast they made a tiny capital gain but with a huge amount of risk. 

Like Buffett, the focus of your portfolio should be growing your capital base over time, and so staying fully invested when the market is so expensive (and potentially volatile) is not the right recipe. 

Focus on steadily building your wealth by being patient, and avoid looking for a quick and dirty 10-20% because inevitably you won’t be able to get out in time.

If you truly are a long term investor, then many indicators are currently flashing red, so be careful out there!

In a forthcoming post we’ll look at how you can also use our 8 timeless investment principles to successfully and safely invest for income in the low interest rate environment.


To find out more about our coaching programs see here.

Criticism of ‘Low Rates, High Returns’

Many ways to invest

It’s important to reiterate that there’s no ‘right’ way to invest, only the right way for you, your present situation, goals, and personality type.

In our book we outline what we believe to be the optimal approach in the current environment, but there are always other ways to invest.

The most important thing is having a systematic plan, staying the course with it, and making adjustments as appropriate upon considered review.

Shedding the home bias

One of the key strands to our approach is the shedding of the inherent home bias.

Investing predominantly at home may well have made sense once, but today it introduces an unnecessary – and easily avoidable – risk of under-performance.

Australia makes up approximately 2–3% of global stock markets.

But we have a very high rate of home bias, with many investors choosing to keep their funds in the home market.

In this respect, we’re not unusual.

Over the past 120 years, Australia has actually been the most successful stock markets, with amongst the highest returns.

But remember that sort of timeframe is not applicable to you as an individual investor.

Bull and bear markets count!

Aussie companies do derive some of their revenue from overseas, but still there have been many periods when the Australian market has under-performed overseas markets.

This is why diversification makes sense when you can so easily take advantage of overseas markets that offer potentially higher returns.

When local stock market expected returns (especially in the low interest rate environment) look to be low, overseas markets may still provide opportunities to generate solid investment returns.

This is why we adopt a global approach to investing, in order to generate returns consistently through the cycles.

Testing our hypothesis

A strange thing with the internet is that if someone has a different viewpoint to you they can often take any point of difference quite personally.

And this leads on to ad hominem attacks or personal slights.

No big deal there, we’re old enough and ugly enough not to be bothered by any of that nonsense.

Remember, there are many personality types and many ways to invest!

But genuine critiques we’re always interested to hear.

We’ve intended our strategy to be as robust and watertight as possible, and have developed it accordingly, so naturally we openly welcome constructive criticism.

Here are some of the most common criticisms we have had (and our thoughts):

Criticism of Low Rates, High Returns

Here are some of the common questions or criticisms:

-‘You can’t time the market

We do agree that it’s impossible to consistently time markets very accurately, and personally we’re not big on using technical analysis (it’s possible to wait for confirmation of an uptrend before investing, for example).

That said, you don’t actually need to have great market timing skills; you just need to be able to see when a market is very cheap, and if you average sensibly into an investment the returns will come, thanks to mean reversion.

Have a look back through history and you’ll see that big opportunities to buy low come around regularly.

Take the recent example of Pakistan after its index crashed 70% – this is what we looked at 6 months ago:

Which do you think will perform better:

-a country where stock prices are down 70%, with PE ratio of 8, and a dividend yield of 9.4%; or

-the US where valuations are at their highest levels since the tech bubble, and levitating at a CAPE ratio that’s never previously been sustained?

It’s not a trick question!

Of course Pakistan had its issues with high interest rates and other economic challenges (aren’t there always?), although there’s a great swathe of Chinese investment underway too.

But with a yield and value like that on offer you don’t need to overthink things (ever more detailed analysis isn’t a requirement, or often even helpful) or catch the exact bottom of the market.

More than 50% of gains later, it’s still cheap, and we’re still holding.

Over a 10-year or 20-year time horizon returns are largely determined by the price you pay, and much of the rest is noise.

There’s always some reason or other why economies are going to boom (or crash), but that tells you little about stock market returns, and in fact an economic boom is often negative for future returns over the coming decade.

-‘Taxes and transaction costs are too high if you buy and sell

Broker fees can thankfully be fairly negligible these days.

It’s true, however, that if you buy and sell assets within 12 months then there can be significant capital gains tax to pay.

Our approach does involve selling assets when they’re fully valued, but it’s still an approach still founded upon investing not trading, and ideally we look to own investments for much longer than a year (thus qualifying for the capital gains tax discount).

We like to hold assets for as long as they represent good value.

For example, we’ve been invested very profitably in Russia since 2014, and continue to hold very happily, with returns to date of over 200%.

We note that whenever the Aussie market becomes cheaper again then we’re all for adopting a passive approach at home too.

We don’t, however, want to commit the cardinal sin of giving all of our hard-earned gains back again in the next bear market.

So, we rebalance, and take a profit, and a bit of tax is a small price to pay for that.

-‘International/emerging markets are too volatile/sound dodgy

Emerging markets in particular can be volatile, but volatility is not the same thing as risk, and indeed it can be your friend when it throws up wonderful opportunities to buy a dollar of value for fifty cents.

Corporate transparency is weaker in some countries, so owning an index may be safer for you than individual stocks, in many cases.

These days you can buy emerging markets ETFs with vast diversification if you do want to minimise volatility, but that shouldn’t be necessary if you buy low, and average into a position.

You can also invest in developed markets, sectors, and styles to diversify.

-‘What about foreign currency movements?

This is an excellent question, with a few possible solutions.

A simple approach is to take a judgemental view each time you invest, which is one viable option, albeit sometimes tricky to execute effectively.

Another way is to recognise and accept that, over the course of multiple investments, the ups and downs of currency fluctuations will likely wash through and balance themselves out over the years.

Alternatively you can hedge, or buy and sell in US dollars, or use other mitigation strategies.

It doesn’t necessarily matter which your favoured approach is, but pick one and stick to it.

-‘Holding cash is a drag on returns

In a bull market, this is true.

Holding cash does give you a buffer, however, and it also means you can generate higher returns on your capital when the market is offering higher returns.

You don’t have to be 100% invested at all times if the returns aren’t there.

Holding some cash or liquid funds is actually desirable if it means you can compound your wealth faster later.

-‘It all sounds too much like hard work

There’s definitely something to be said for simplicity, so, for example, you might like to keep to about a dozen positions.

And it’s also the case that if you’re moving into your later years with a spouse who has no interest in investing, you may wish to have a simple set-and-forget strategy in case you depart first.

The goal of our book is simply to outline a proven method for generating strong returns in a low risk fashion, given the current low interest rate environment.

In our view that means taking a global approach, and being cautious about the extremely high valuations in the US and some other developed markets.

Not everyone needs to generate anything more than the income on offer from the market, of course, especially in their later years, though we believe our approach can also help to limit downside risk.

Thus we adopt our 8 timeless investment principles, combined with a Kelly capital growth strategy, including the Kelly Criterion for position sizing.

This does involve more thinking than a purely passive approach, although it’s entirely possible to adopt an approach that simply involves rebalancing your portfolio quarterly, or even annually.

-It sounds too complicated

It’s not that’s hard, honestly!

In many ways the beauty of our approach is in its simplicity.

Analysts often think that more and more detailed analysis is helpful.

But really you want to paint with a broad brush, and look for opportunities with limited downside and huge upside.

To learn more about our coaching programs see here.

This is how you can invest for value (without losing money)

Investing for value

Plenty of people like to think of themselves as ‘value investors’, but when push comes to shove they’re often circling the same few stocks as everyone else, partly due to their home bias.

Value investing is about buying a dollar for fifty cents (or as cheap a price as possible).

Today, a short look at how that can still be possible in today’s investment world.

Don’t lose money

Rule #1 of investing is ‘don’t lose money’.


Well, we know that a 25% gain is wiped out by a 20% loss.

And if you lose 50% of your capital then you need to make 100% just to get back to where you were.

Long-term buy and hold investors must steel themselves for the possibility of markets falling by 30-60% (which can occur surprisingly often), or even as much as 90% (yes, history shows that this can happen, even in the US).

There’s another aspect to this, and that’s if you look towards buying markets showing value – often those that have already experienced significant drawdowns – you can potentially generate significantly stronger returns on the rebound, often with lower risk.

Investing through a value lens can help in this regard, by directing you towards cheap markets, and away from expensive markets.

When markets go on sale

Investing is perhaps the only place where when things go on sale people run out of the store.

Why do people suddenly become paralysed with fear when markets get cheaper?

In nearly all other fields of life, when things become cheaper people buy more!

Yet paradoxically people seem to like stock prices to be high, but they panic and run away when prices crash.


Sentiment towards stocks was at its most bullish on 6 January 2000 (as the peak of the unprecedented tech bubble was imminent), and at its most bearish on 5 March 2009 (literally the market bottom, after the biggest financial event since the Great Depression).

You almost couldn’t make it up, but that’s precisely what the AAII Sentiment Surveys showed!


This is exactly why investors should focus on statistics, not stories!

Measures of value

Of course, there’s no single method for reliably measuring value in a stock market.

But if you run a series of metrics (market cap to GDP, price to book, price to sales, etc.) then most of them should align when a market is overvalued.

And, for the US at the time of writing, that’s just what they do.

Source: Hussman

This chart alone suggests that holding some cash is likely to be prudent.

Yet even extremely high valuations don’t necessarily ensure large losses.

Momentum and speculative sentiment matter in the short term.

However, if you look over 10-year and 20-year time horizons, then value measures such as the CAPE ratio – although marginally impacted by changes in accounting standards, such as to the amortization of goodwill – have had a strong predictive power for expected future returns.

Significant outperformance is frequently delivered relatively quickly from market buy signals, within 12-24 months, before the gravity of mean reversion takes hold.

Sometimes the strong returns can take a few years to materialise.

Can you time the market?

It’s true that you can’t time stock markets reliably to the week or month.

But you can clearly see when markets are offering value and when they aren’t (it may also be possible to use trends to time your entry, if you’re so inclined).

Sometimes stock markets can fall for long periods, while even a cheap market can become cheaper.

Brazil’s economic crisis has been one of the more extreme examples over the past decade, with the stock market index falling sinking lower for five long years between 2011 and 2015, before finally delivering enormous returns (the index value has since ripped more than 150% higher, from 43,000 to 115,000 points).

Capturing the upside

Few people have the desire to invest through a multi-year bear market, so how can such a risk be managed?

The first and most important point is to wait patiently until markets are cheap, so you can step over one-foot hurdles (e.g. in Brazil’s case the CAPE ratio at just 7 became a screaming buy signal in the midst of the crisis in 2015).

Note that when markets become this cheap (in Russia’s currency crisis its CAPE ratio fell to under 5) then it’s never a comfortable time to invest – that’s why everyone else is panic-selling.

A second element of the value strategy is to stage your entry into the investment, so you can average down if you need to.

In other words, if a cheap market gets even cheaper, you can happily buy more stocks.

And thirdly, remember the risk hierarchy: averaging down is psychologically much easier to do into a market index than into an individual stock, due to the company-specific risk.

A struggling company can fail, but a country index is unlikely to (if you’re going to average down into an individual stock, it should probably be a large, safe, well-established and systemic company, with consistently solid earnings and low debt etc.).

Being contrarian

Investing in cheap markets tends to pay very handsome rewards, and with reduced drawdown risk.

Most fund managers can’t do this – they’re understandably too fearful of going against the grain, or straying too far from their benchmark and getting fired.

But as an individual investor, you can invest however and in whatever you like.

Forget the US in 2020, the bargains will be elsewhere.

To find out more about our coaching programs, see here.

Understanding yourself, cycles, and your risk tolerance

Understanding yourself and risk

Understanding yourself is critical in developing an investment strategy and sticking to it when the pressure is on.

Interestingly, this ties into our notions of risk.

The first question a financial advisor often asks is: ‘What is your risk level?’.

The first problem is that most of us have no idea!

Most folks end up saying: ‘Um, about average, like everyone else?’.

The second challenge is that your risk tolerance will tend to fluctuate with whatever’s currently happening.


Because when the stock market has fallen by 50% and the media is running a series of doomsday headlines, then you’re unlikely to be thinking ‘Wow, what a great time to put a lot of money into the stock market!’ (it usually is, by the way).

We’ve watched people spending their money, and it often makes little logical sense.

For example, we have a friend who is extremely risk-averse and sees the stock market as an unfavourable gamble (he currently holds a few hundred thousand dollars in cash, earning next to nothing).

But he will happily spend $500 per week gambling on horse racing and football (and probably two flies racing up a wall, for all we know!).

Logical? Hardly.

We could offer our friend an excellent, conservative investment strategy which makes solid returns, but he’ll never budge because he’s wedded to his beliefs, which stem from his innate personality and approach to money.

Our individual personality heavily influences our approach to money: what money means and how it should be spent or invested.

My spending may not make sense to you, but that may be because we have a different personality type from each other.

Many things we do may not make sense to others, unless they are of the same personality type.

We’ve seen this constantly on several levels.

Market cycles

Apart from the extremely high valuations in US and some other developed stock markets, there are any number of soft indicators of a market cycle ‘in its eighth inning’.

One is the apparent redundancy of old industries as a new wave of genius entrepreneurs (Musk, Bezos, and others) sweeps to the fore.

Another is a rise in optimism about future returns and recency bias as market momentum delivers positive returns for several years in a row (in this case 11 years consecutively!).

It’s been an outstanding stretch for a passive approach with the S&P 500 roaring 400% higher from 666 points to 3,330 since 2009, but in the words of Kenny Rogers you should ‘never count your money when you’re sittin’ at the table’.

Yet some are loathe to believe markets are too expensive…

Real world risk tolerance

If you started investing after March 2009, it’s very likely that your risk tolerance isn’t as high as you think it is.

One of the dubious advantages of being British-born is having lived through several brutal recessions, when not only were stock markets and housing markets hammered, but turning up to work on a Monday was a nerve-wracking experience as HR indiscriminately frogmarched employees from the premises.

But here’s the thing: from an investment perspective this is often a good time to be more aggressive, not to batten down the hatches.

It’s easy to calmly plug assumed returns and strategies into a spreadsheet.

It’s another matter to execute your strategy without losing faith after several years of negative returns, or if things don’t play out as hoped.

Having a written, systematic plan is likely to help you stay the course.

4 reasons to understand yourself

We seek to understand ourselves for the following reasons:

1. We get to understand our own emotions and see how they impact our stock market investments and our responses to market events;

2. We get to understand why we do the things we do with money as a result of understanding ourselves and what money means to us individually;

3. We get to control our emotional responses better and thus not make bad decisions by simply responding to events. We develop an ability to approach the market and our investments more rationally; and

4. We seek to counter our negative behaviour patterns before we act.

Avoiding the madness of crowds

We aim to avoid the crowd, because we know that the crowd is unlikely to understand much about the investment and what the risks are.

The most effective approach is to have a systematic method that delivers the best probability of you making successful investments based on sensible decisions.

As John Templeton, a famous investor, said:

‘It’s impossible to produce superior performance unless you do something different from the majority.’

It’s difficult to stand alone, but we can tell you this is how you can get better than average investment returns in all markets.

And with more practice, by using a systematic strategy your emotional framework will become familiar with the approach, so it becomes easier over time.

Better returns

There are investors who do consistently beat the market.

Here’s a brief summary of how they do it:

  • They have a system which they stick to and apply. This is usually based on being contrarian – that is, buying when a market is cheap. They don’t wander off into the latest public fad or whatever is ‘hot’;
  • They don’t follow the crowd (act emotionally) – you’ll often find that the most profitable investments are made when everyone else is running in the opposite direction.

For example, we made a series of successful investments in 2009 when the global financial crisis struck (yes, in Sydney properties, as well as in stocks).

And again in 2011 buying US banks after the financials sector was smashed lower:

US Financials ETF Returns

And again in 2014 buying Russia after its currency crisis and stock market crash (yes, Russia! We know what you may be thinking, but these have been hugely lucrative investments that we still hold, as they’re still cheap):

Russia ETF Returns

(Side-note: observe what happened in the 24 months following the 2008 crash. Because out of the outsized impact of negative returns, the most powerful way to compound your wealth safely is to (a) not lose money by investing in expensive markets, and (b) buy markets that are exceptionally cheap).

More recently we picked up bargains after the ‘Brexit’ vote shock, and again in Greece after its 2018 market implosion, and again with the Pakistan ETF after its 70% market crash, and so on.

Remember, think statistics over stories: you’ll find that buying markets that are down 50-80% generally delivers stronger returns than buying euphoric or over-valued markets in the rampant speculation phase (as indeed, you should expect).

The investment universe has opened up marvellously – there’s no logical reason to have such an ingrained home bias these days, and wonderful opportunities to buy markets low come around regularly.

On each of these occasions, investing may have appeared on the face of it to be a dangerous gamble (at least, if you believe everything you read);

  •  They follow market cycles and understand that there are times when it is better to buy and better to sell;
  • Most of them use a rational decision-making approach when allocating their capital; and
  • They don’t put all their allocated funds into the market at once. They may choose to ‘average in’ to an investment because they’re aware that even cheap stocks and markets can get cheaper.

The proof is in the returns generated over a long period of time, and the dramatically superior performance of buying and selling shares using the value (e.g. CAPE ratio) or contrarian method.

Source: Meb Faber

The fundamental edge that value investors like Warren Buffett, George Soros, Ed Thorp, and many others have used to beat the market is rooted in the psychology of individual investment behaviour, and this approach has been successful for the past 75 years.

Remember, though, if you don’t know much about yourself, then the stock market can be an expensive place to find out!


To find out more about our coaching programs see here.

Total money management: 3 Wells of wealth for genuine financial independence

What is financial independence?

Today, a short discussion on how you can invest for true financial independence.

Ideally, we like to think of personal wealth in 3 Wells, as follows:

Well 1 – Liquid funds (<12 months)

These liquid funds can be actively managed, and while not a significant percentage of your overall wealth, should be large enough to cover your day-to-day bills and living expenses for the coming year.

Of course, if you don’t have the liquid funds to cover your next 12 months of living costs then you can’t be financially independent;

Well 2 – Living, lifestyle, and leisure (2 to 5 years)

Well 2 is a second pool of money which can also be actively managed to cover upcoming living expenses, holidays and travel, car upgrades, home renovations, school fees, and whatever else is on your 2 to 5 year horizon.

These tend to be reasonably liquid funds, most often a balance between stocks and cash; and

Well 3 – Longer term and legacy (to retirement & beyond)

These are your safe, long-term investments that you ideally never have to sell until your retirement, typically including property and, for some, safe investments in large, established, systemic companies which throw off strong income streams.

If you manage your first two wells successfully then you may never need to touch these assets, and they can go on compounding your wealth for as long as you  live.

These investment assets can ultimately form a legacy for your kids, or for other family members, or for a charity of your choosing.

How markets fit into the 3 Wells

The strategies discussed in our book and on this blog using the 8 timeless investment principles can most obviously be applied to Well 2, being your 2 to 5 year funds.

A healthy balance of stocks and cash to take advantage of opportunities lends itself perfectly to this pool of your wealth.

Well 3 tends to comprise your superannuation, investment properties, and other long-term investments.

But what about Well 1, being your short term funds?

Earning more on your money

It’s also possible to apply our timeless investment principles to a short-term trading strategy with more regular rebalancing.

Rigorous back-testing shows that our trading strategy comfortably outperforms any buy and hold strategy over any meaningful time horizon.

Short-term money management (Well 1)

What if we told you there was a successful way to use a trading strategy but also class yourself as a long-term investor? 

In our 3 Wells program we’ve further developed our 8 timeless investment principles that can teach you how to be a successful long term investor.

We have a trading strategy which works for the long term, but requires a simple 15-minute attention to the daily machinations of the stock market.  

Many will scoff that you can’t make money buying and selling in the short term because of taxes and transaction costs.

Well, our strategy, which has been back-tested, and also used by Pete and Steve as part of their investment approach, will outperform most (if not all) other investment strategies. 

Your objectives matter

Now, this trading strategy isn’t for everyone.

We all have different objectives when it comes to money, and some folks don’t want to spend even a small amount of time each day thinking about stocks.

In saying that, when our clients see the simplicity and logic of our approach they’re invariably keen to implement it. 

We call this our Well 1 trading strategy and it generates wealth and profits in the shorter term which add up to long term gains.

It’s like having a second job, without the hard labour.

Sounds too good to be true, but it’s not…

Well 1 money management

This trading strategy, which takes about 15 minutes per day at the most, has been proven to outperform a buy and hold strategy over the long term. 

The strategy challenges much of the standard thinking regarding investing, such as:

1. You must only invest for the long term

2. Focus on buying ‘the best’ companies

3. No-one can really make money day trading

4. You must be either a trader (short term) or an investor (long term)

5. Investing is best left to ‘the professionals’

Of course, there are plenty of traders/investors who make solid investments returns over shorter time-frames than ‘the long term’. 

Principles still apply

The trading strategy still utilises our 8 timeless investment principles.

And in our Well 1 trading strategy you don’t have to spend large amounts of time researching individual stocks or buying and selling lots of companies every day.

In fact, as you already know from our 8 timeless investment principles, it negates the need to use individual stocks

Day trading in many ways is exceptionally tough, and there are many traders out there who fail at generating any substantial gains.

But this is not day trading – our unique approach generates long term investment returns with a rigorous application of the underlying principles. 

Total money management

In our 3 Wells approach, we view investing through the lens of time.

That is, a complete approach to building your total wealth using short, medium, and long term investing.

There’s no logical reason to label yourself as one or the other – trader or investor.

In our approach, if you want, you can be both.

It simply comes down to how you view the stock market, and how you can choose to generate profits from its constant ebbs and flows.

The benefit of this strategy is that it aligns with our ‘3 Cs’ (cost, choice, and control) whereby you avoid paying crippling fees for a fund manager to dump your hard-earned money into the ASX 300 and fail to deliver any out-performance.

It doesn’t require any special investing skills or secret knowledge, as we will demonstrate.

Total money management.

To find out more about our coaching programs see here.

Maximising your long-term wealth with the Kelly Criterion

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.

Remember, you don’t need to be an expert stock picker today – you can invest in country or sector ETFs when they’re ‘on sale’ to generate wealth-producing returns, if you buy low and sell high.

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.

Kelly characteristics

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.

Information requirements

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.

Capital Growth Theory: how to maximise your long-term wealth

Position sizing

If you’ve ever played blackjack at the casino you’d be familiar with the concept of bet sizing.

You don’t bet the same amount regardless of your hand; instead you aim to place larger bets on high probability events.

Here’s a very simple formula where ‘p’ is the probability of winning, expressed as a percentage, and ‘x’ is the position size:

2p – 1 = x

It’s very logical: if you’re less than 50% certain of an outcome then that’s no better than a coin flip and you shouldn’t bet, whereas if you’re 100% certain of success then you go all in!

Of course, in the real world few things are 100% certain, and when it comes to investing you’ll need to adopt a different and more conservative stance.

Capital Growth Theory

If you want to maximise your long-term wealth from investing then you can think of your strategy as a series of repeated similar bets.

The Kelly Optimization model can help you to determine what fraction of your available capital should be allocated to a new investment.

The advantage of the Kelly model is that it maximises your long-term gains, and can help you to minimise losses.

As a general rule, where there’s a reasonable margin of safety, you can maximise returns by increasing your exposure, but this only works up to a certain point.

For one thing, no outcome is certain, and you also shouldn’t over-bet as there will always be other great investment opportunities in the future.

For this reason, many investors choose to use a fractional Kelly strategy to manage risk.

The traditional view

Capital Growth Theory differs from the traditional Modern Portfolio Theory (MPT) taught in business schools.

In the real world we don’t have to invest all of our money today, or indeed in any given market.

Unlike a fund manager, an individual is not bound by a mandated asset allocation, the demands of nervous investors, or the need to benchmark against an arbitrary index or other measure of returns each year.

And since some markets are much cheaper than others, we can use this information to our advantage.

Most investors aren’t very good at stock picking – it’s surprisingly challenging to get right over time – but these days you can buy country or sector ETFs, so you don’t necessarily need to be.

What we’re really interested in is maximising our wealth for the long term, and there will be numerous wonderful investment opportunities in the future to help us achieve that goal.

The Kelly capital growth strategy is the approach that’s mathematically proven through simulations to maximise long-term expected wealth.

Variations of Kelly strategies are used by some of the wealthiest and most successful investors of all time, including Jim Simons, Bill Gross and others.

Thinking in bets

When you contribute to your superannuation fund a portion is invested in the markets regardless of the environment, according to the fund’s allocation.

It’s often noted that super funds don’t beat the market, but when you think about it that’s not really what they’re setting themselves to do.

Super funds generally track the fortunes of the market, and the name of the game is maximising assets under management (and their fees), not your long-term wealth.

To a certain extent institutional investors are the market these days, so in aggregate fund manager returns lag the market due to the fees and transaction costs.

But those of us managing our own money strategically as a series of bets know that the odds of success are considerably higher when markets are attractively priced.

Impressive and substantial gains are achievable, provided you practise careful risk management, although there may be more volatility in your portfolio from month to month.

Indeed, using a Kelly capital growth strategy can see your wealth exceed that of any other strategy, and by more and more as the horizon becomes more distant.

Next we’ll take a look at the Kelly Optimization model in action.

To find out more about our coaching programs see here.

The benefits of effective asset allocation

Asset allocation

If you see your financial advisor they’ll likely recommend that you allocate your assets between property, stocks, and cash (partly due to the tax incentives for real estate and equities in Australia).

That’s because all asset classes have summer and winter seasons.

Source: Novel Investor

Sensible asset allocation can help you to adopt a disciplined, long-term approach to building wealth, while helping you to see the big picture.

And while one asset class isn’t delivering another might be, so this can bring smoother risk-adjusted returns to your portfolio.

However, because of increasing globalisation over the past 30 years or so, certain asset classes may have increased in their correlation, so it may not be quite as simple as it used to be.

Source: Novel Investor

Still, asset allocation remains an important investment principle that we use to minimise risk and maximise our investment returns.

Asset allocation and timing

The legendary football player and then coach Knute Rockne once said:

‘As a coach, I play not my 11 best, but my best 11.’

This is also how you should think about your portfolio.

Even if equities are the best performing asset class over the long term, your timing is still important.

Closer to home, astute asset allocation is aptly demonstrated by Australian residential property in Sydney and Melbourne booming while the ASX meandered back and forth. 

Asset allocation – in two parts

(i) Macro allocation

This simply means dividing your funds between your chosen asset classes, and partly because of tax incentives in Australia this allocation is normally dominated by stocks and property.

We can also include cash and bonds as they can be useful asset classes for protecting capital.

Since we understand market cycles, we believe there is ample evidence to show that moving between asset classes at the macro level can increase your returns.

For example, investors in Sydney in 2011/12 made excellent investment returns simply by choosing property when it was on the cusp of a large increase.

The same can be done for stocks using market cycles and the CAPE ratio.

With the advent of ETFs, which allow us to buy country indexes, US sectors, and styles, we can use the cycles to increase our returns.

When stocks are cheap, you should consider allocating more of your funds to stocks in order to gain from the increased returns on offer.

When stocks are expensive and offering minimal or below-average returns, then you should pivot to alternative asset classes such as property or cash.

Remember, cash has an important role to play because it’s uncorrelated with stocks, it gives you a safety buffer, and it gives you the optionality to buy stocks when they do become cheap.

(ii) Micro allocation

Micro allocation is how we divide our funds once we have determined our macro allocation.

An example will suffice.

Let’s use US sector ETFs, where we might be looking to invest in the most out of favour sectors.

Then we would go on to look at the CAPE ratio for each sector.

You may choose three methods to invest:

  1. Invest in all the out of favour sectors equally because while some investments will seem more appealing and appear to have more potential, you can’t always be sure; or
  2. Invest in all sectors but adjust the initial amounts according to some indicator (you may choose a greater weighting based on market cycles and where the sector performs best in through the business cycle); or
  3. A judgemental selection of sectors – we believe this is a sound approach as it allows you to adjust your allocation according to our 8 timeless principles (for example, mean reversion and CAPE ratios)

Under this method, you would select those sectors that have the best expected returns.

We often favour buying the bottom three performers (‘the losers’), and then allowing mean reversion to play its role in delivering solid investment returns.

Notice how over an extended period that no one sector dominates, and so they swap positions.

Leaders become laggards, and vice versa.

Many investors over-allocate or allocate the full 100% of funds rather than keeping some cash allocated against the stock.

This is often done because you think the opportunity is so good.

So many folks leave themselves no wriggle room or opportunity to buy after their initial allocation.

However, it’s more prudent if you choose $10,000 as your potential allocation, to initially spend $5,000 and hold $5,000 against it in cash.

After all, none of us is clairvoyant – we can’t pick the bottom of the market precisely – and so it pays to keep some of your powder dry in case the price sinks lower.

This can often be the case because you are buying when the sector or country is out of favour – but remember that is when the best returns are on offer.

Cash is (sometimes) king!

Cash is uncorrelated to equities, and is important for several reasons.

Firstly, cash gives you options.

As Warren Buffett said, holding cash is painful but a lot less painful than making a dumb investment decision and losing money.

Although we can’t predict what future opportunities may arise, cash allows you to take advantage of them when they do.

Secondly, having cash against each stock allows you to add additional funds if the stock falls.

We’ve found this to be very reassuring psychologically.

We have the knowledge and emotional comfort of having cash available should the stock price fall, and so we can put our cash to work and realise that we are reducing our average entry price as the stock falls.

And over time you will find that holding cash (which does at least earn a small amount of interest) helps you to outperform the market.


Remember: Markets can be volatile!

And this volatility can be your friend because it throws up opportunities.

Holding spare cash gives you a greater range of options to add more stocks during those intra-year declines.

Stock markets can fall 20% to 40% in a very short space of time, and if you have cash, you can take full advantage of these falls.

Even better, when the CAPE ratio is low – and by now we hope you are realising what type of market and where in the cycle you are presently – it is important for asset allocation.

You can adjust your asset allocation according to the expected return.

Expected returns are not an exact science, but in general, we know that when the expected return is high, you should consider increasing your initial allocation.

So if the expected return is high (as happens when asset classes are cheap and out of favour), then you may, for example, start with a 70% allocation and hold 30% in cash.

To find out more about our coaching programs see here.