Have you ever been in the situation where you wanted to make a risky investment but weren’t sure how much of your capital to put into this bet? Often this uncertainty ends up delaying the decision and either you lose the application or make it in an inappropriate size. I explain below a simple formula for you to measure the percentage of your capital to put at risk.
For example, the dilemma about which amount to invest in the stock market this Friday, in view of the election on Sunday, was common to many investors.
Have you ever thought that in some past investments you made a small allocation and were frustrated by it or that you bet too big and regretted having made it? What is missing is a criterion for this decision.
You who accompany me know that I insist that everyone has a strategy. Of course, there is no single strategy that works every time and you never lose. But, the strategy I’m going to explain today is mathematically robust.
Having a strategy is essential, as it is the process that guides your investment decision. That way, you know when you might be committing some excess risk or even conservatism.
The amount to allocate to a risky investment is described by a simple formula. Although simple, it requires some assumptions that for many can be difficult to estimate.
However, if you have trouble making these estimates, beware. You should rather think about not making the investment, and research better. Difficulty estimating is an indication that you may not know what you are doing or what risk you are taking.
The formula is known as the Kelly criterion.
The name comes from its creator, American mathematician John Larry Kelly Jr. It was released in the 1950s, but is still used today.
In an interview in the book Asymmetry, Mathias Fulda shows that the Kelly criterion is used by the manager Kadima. In the book Formula of Fortune, William Poundstone describes that the criterion is used by many fund managers.
The Kelly criterion that describes the amount K to be allocated in a risky investment is calculated by the formula: K = S – [(1-S)/(G/P)].
In this formula it is necessary to estimate three parameters: S represents the probability of your bet being successful, G is the percentage of how much you win if the investment succeeds and P is the percentage of your loss if it goes wrong.
For example, the Ibovespa closed this Friday at 114,500 points. Consider the following premises:
Do you believe that if candidate A wins, a 5% appreciation is expected to reach 120,200 points;
If candidate A loses, the market is expected to drop to 104,000 points, that is, a drop of 10%;
Finally, you believe that the probability of Candidate A winning is 70%.
Therefore, of its total capital, the amount to have invested in the stock market considering this hypothetical scenario would be 10%. Substituting the parameters in the formula: 0.7 – (0.3/(0.05/0.10)).
This was just an illustrative example. The process can be used when you intend to make investments in events like this or in a specific action.
Comment here your calculation thinking about the election event. Please, without mentioning the candidate’s name, write what you believe probability of winning and expectations of gain and loss you have for this investment.
Michael Viriato is an investment advisor and founding partner of Investor’s House
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