Kelly Criterion and Your Fun Money Allocation

Do you think you’re a below-average driver? I didn’t think so. In the same vein, Jason Zweig had a funny tweet the other day that hit home:

Admit it: You do it, too.https://t.co/DaI0DON3XK pic.twitter.com/S9F3ILMiNz

— Jason Zweig (@jasonzweigwsj) October 2, 2017

His linked article ends with this advice:

Put 90% of your money in low-cost index funds and lock yourself in by adding a fixed amount every month through an electronic transfer from your bank. […] Speculate with just the remaining 10%, and use a checklist of buying criteria to make sure you never buy a stock purely because it has been going up.

This coincided with me reading stuff about the Kelly Criterion, a mathematical formula used to determine the optimal size of a series of bets. Basically, the greater your “edge”, the greater your bet size should be. If you have zero edge, then you should bet nothing. If you have negative edge, you should theoretically bet against yourself (if only casinos allowed that).

Here’s an interesting example that involved a special coin where you have the advance knowledge that it has a 60% chance of heads and 40% chance of tails. In short, with this edge you should consistently bet 20% of your bankroll each time. That’s it! If the coin was 52.5% heads/47.5% tails, you should only bet 5% of your bankroll. Most people do not find this intuitive.

What’s your own edge? Consider that some folks think that only 5% of Active Investment Managers Will Add Value. This is where I insert a couple of Charlie Munger quotes:

I think it is roughly right that the market is efficient, which makes it very hard to beat merely by being an intelligent investor. But I don’t think it’s totally efficient at all. And the difference between being totally efficient and somewhat efficient leaves an enormous opportunity for people like us to get these unusual records. It’s efficient enough, so it’s hard to have a great investment record. But it’s by no means impossible. Nor is it something that only a very few people can do. The top three or four percent of the investment management world will do fine.

If you stop to think about it, civilized man has always had soothsayers, shamans, faith healers, and God knows what all. The stock picking industry is four or five percent super rational, disciplined people, and the rest of them are like faith healers or shamans. And that’s just the way it is, I’m afraid. It’s nice that they keep an image of being constructive, sensible people when they’re really would-be faith healers. It keeps their self respect up.

Bottom line. In stock market investing, most of us lack an edge and thus should stick with index funds. But we all like to think we have some edge, so maybe a 5% or 10% fun money allocation is acceptable. Anything higher would be claiming to have some crazy, unreasonable edge. I would say it also depends on how aggressively your fun money is managed. Berkshire Hathaway stock is relatively low risk. Mine is invested in short-term loans backed by real estate with conservative loan-to-value ratios and a target return of 7%. The latest cryptocurrency promoted by celebrities on social media? Not low risk.