Kelly Criterion for investing

The Kelly Criterion defined by one source:

John Kelly, who worked for AT&T's Bell Laboratory, originally developed the Kelly Criterion to assist AT&T with its long distance telephone signal noise issues. Soon after the method was published as "A New Interpretation Of Information Rate" (1956), however, the gambling community got wind of it and realized its potential as an optimal betting system in horse racing. It enabled gamblers to maximize the size of their bankroll over the long term. Now the system is used by many as a general money management system in not only gambling but also investing.

The Basics
There are two basic components to the Kelly Criterion:
• Win probability - The probability that any given trade you make will return a positive amount.
• Win/loss ratio - The total positive trade amounts divided by the total negative trade amounts.

These two factors are then put into Kelly's equation:
Kelly % = W – [(1 – W) / R]

Where:
W = Winning probability
R = Win/loss ratio

The output is the Kelly percentage, which we examine below.

Kelly's system can be put to use by following these simple steps:

1. Access your last 50-60 trades. You can do this by simply asking your broker, or by checking your recent tax returns (if you claimed all your trades). If you are a more advanced trader with a developed trading system, then you can simply back test the system and take those results. The Kelly Criterion assumes, however, that you trade the same way you traded in the past.
   
2. Calculate "W", the winning probability. To do this, divide the number of trades that returned a positive amount by your total number of trades (positive and negative). This number is better as it gets closer to one. Any number above 0.50 is good.
   
3. Calculate "R," the win/loss ratio. Do this by dividing the average gain of the positive trades by the average loss of the negative trades. You should have a number greater than 1 if your average gains are greater than your average losses. A result less than one is managable as long as the number of losing trades remains small.
   
4. Input these numbers into Kelly's equation: K% = W – [(1 – W) / R].
   
5. Record the Kelly % that the equation returns.

Interpreting the Results
The percentage (a number less than one) that the equation produces represents the size of the positions you should be taking. For example, if the Kelly percentage is 0.05, then you should take a 5% position in each of the equities in your portfolio. This system, in essence, lets you know how much you should diversify.

The system does require some common sense, however. One rule to keep in mind, regardless of what the Kelly percentage may tell you, is to never commit more than 20-25% of your capital to one equity. Allocating any more than this is carries far more risk than most people should be taking.

Is It Effective?
This system is based on pure mathematics. However, some people may question whether this math originally developed for telephones is actually effective in the stock market or gambling arenas.

By showing the simulated growth of a given account based on pure mathematics, an equity chart can demonstrate the effectiveness of this system. In other words, the two variables must be entered correctly, and it must be assumed that the investor is able to maintain such performance