Tuesday, February 03, 2009

Gambler's Ruin Takeaways

Well actually, Gambler's Ruin has more to do with speculating than investing. Nevertheless I think we can learn a few things from Gambler's Ruin.

Btw Kelly's Formula is

% of money = odds of winning - (odds of losing / payout)

Eg. You think Stock A that have a 60% chance of going up 80%
Then % of money = 0.6 - (0.4 / 0.8) = 0.1

ie you should be putting at most 10% of your money in this stock
But take note that ALL the inputs are arbitrary, the odds, the payout.
The formula output is only as good as the inputs.

Ok here are the takeaways:

1. If you simply buy a fixed dollar amt, like $1,000 for every stock you will go broke as time passes, even if the odds are fair. And you will go broke even faster, esp if the odds are against you. (As far as investing is concerned, in most cases, the odds ARE against you).

2. Even if the odds are in your favour, betting the same absolute amt doesn't make sense, you need to apply Kelly's Formula or its variations to optimize returns. This means that you should always decide how much money to invest based on a % of your total amt of money and not an absolute amt. And this % should be decided by the Kelly's Formula or some modifications (half Kelly etc) of it.

3. Building on the previous point, one of the most popular implementation is actually the much talked about rebalancing method used by institutions and shrewd indvidual investors. Say you have 60% in stocks, 30% bonds and 10% cash. You should rebalance your portfolio whenever the ratios are out of whack. Like maybe stocks go up to 70% during boom time, so bring it down back to 60%. This makes sure you buy low and sell high and at the same time mitigate Gambler's Ruin.

Ben Graham, father of value investing, advocates always maintaining a ratio of 50:50 in stocks and bonds (with possible digression to 25:75 or 75:25). In the same line of thought, when the ratios are out, say stocks go from 50% to 80%, then you should bring it back down by selling. This ensures that you buy when it is low and sell when it is high.

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