I Love the Kelly Optimization Model

I have a confession to make. My rating in our own Motley Fool CAPS community stinks. As a Fool who writes primarily CAPS-related articles, that's a tough pill to swallow! There's just one reason I'm not crying myself to sleep this Valentine's Day: My portfolio in real life has been oh-so-good to me.

Why the discrepancy? I owe it all to a smart, wonderful, and drop-dead gorgeous formula that I'm just head-over-heels for -- the Kelly Optimization Model.

CAPS is a stock-picking game -- not a portfolio management game -- so it rewards you for having a greater number of accurate picks, and it weighs each selection equally. That makes sense, because CAPS' goal is different than merely mimicking portfolio performance. But when it comes to real-world returns, the manner in which you allocate (or weigh) your portfolio accounts for the vast majority of the actual money you make. That's where Kelly comes in handy.

The Kelly model -- simply stated as edge/odds -- is the most important formula in all of investing (or any other "game of chance," for that matter). Developed by J.L. Kelly, the formula is based on the deceptively simple concept of weighing your portfolio in direct proportion to the edge, or confidence level, that you have in each stock. In other words, Kelly urges you to bet a bigger amount as your probability of winning increases.

For example, I own more than 20 stocks, but just four of them -- CryptoLogic (Nasdaq: CRYP  ) , Fairfax Financial (NYSE: FFH  ) , Ipsco (NYSE: IPS  ) , and Sino Forest -- account for nearly 60% of my portfolio. They're all based in Canada (like me), and in my eyes, they were no-brainer investment decisions in which I had the utmost confidence.

They've all performed great since I purchased them, and since they carry most of the weight in my portfolio, I've been able to reap the rewards. Obviously, the Kelly Formula isn't an exact science, but it forces you to really question the courage of your convictions.

So, even though all the stocks I've purchased, on average, have had subpar performance -- as evidenced by my horrid CAPS rating -- my real-world portfolio has managed to outperform. I have the beautiful Kelly model -- and the important lesson of swinging hard at fat pitches -- to thank for that.

What's sending Fools' hearts aflutter? Go back to our intro page to see what else we have a crush on.

CryptoLogic is a current Motley Fool Hidden Gems pick. Discover Tom Gardner and Bill Mann's complete lineup of superior small-cap stock selections free for 30 days.

Foolish contributor Brian Pacampara tried to use the Kelly model in a Foolish game of poker, but got a lucky card on the river to win, instead. He owns shares of all of the companies mentioned. The Fool's disclosure policy always knows how to weigh itself.


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