Poker & Investing

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The Safe Investor
June 03, 2024

The Kelly Criterion: A Winning Formula for Dividend Investing

Hello,

In the world of dividend investing, finding the right strategy can feel like searching for a needle in a haystack. Today, I want to share with you a powerful tool that has guided some of the greatest minds in both investing and gambling: the Kelly Criterion. This method is particularly effective for dividend investors seeking to maximize returns while managing risk.

Warren Buffett’s Bet on the Kelly Criterion

Warren Buffett, one of the most successful investors of all time, has often emphasized the importance of calculated risk-taking. While he may not explicitly talk about the Kelly Criterion, his investment strategies reflect its principles.

Buffett once shared a story about his early investment days. He spoke of a time when he was faced with a choice between investing heavily in a few promising dividend-paying companies or spreading his money across many to minimize risk. Instead of diversifying excessively, he chose to put substantial bets on his best ideas – a principle that aligns closely with the Kelly Criterion. This strategic allocation allowed him to maximize his returns while managing risk effectively.

The Poker Connection

To understand the Kelly Criterion, let’s delve into a scenario from the poker table. Imagine you’re in a poker game, and you have a hand that you’re confident will win. If you bet too little, you miss out on potential gains. If you bet too much, you risk losing a significant portion of your bankroll. The Kelly Criterion provides a formula to determine the optimal bet size to maximize long-term growth while minimizing the risk of ruin.

The formula is: Fraction of bankroll to bet=𝑏𝑝−𝑞𝑏Fraction of bankroll to bet=bbp−q

𝑏b is the odds received on the bet (net odds)
𝑝p is the probability of winning
𝑞q is the probability of losing (1 - 𝑝p)

Applying the Kelly Criterion to Dividend Stock Picking

Now, how does this apply to dividend stock picking? The Kelly Criterion can help you decide how much of your portfolio to allocate to a particular dividend stock. Let’s break it down:

Determine the Probability of Success: Assess the probability that a dividend stock will provide a positive return. This involves analyzing the company's fundamentals, dividend history, and market conditions.
Evaluate the Potential Returns: Calculate the expected return if the investment is successful and the loss if it fails. This will give you the net odds (b).
Calculate the Kelly Fraction: Use the Kelly formula to determine the optimal fraction of your portfolio to invest in that dividend stock.

For example, suppose you believe there's a 60% chance a dividend stock will go up (p = 0.6) and a 40% chance it will go down (q = 0.4). If the potential gain is 50% (b = 0.5), the Kelly fraction would be: Fraction to invest=0.5×0.6−0.40.5=0.3−0.40.5=−0.2Fraction to invest=0.50.5×0.6−0.4=0.50.3−0.4=−0.2

A negative result indicates that the investment is not favorable based on the Kelly Criterion. However, if the potential gain was 100% (b = 1), the calculation would be: Fraction to invest=1×0.6−0.41=0.2Fraction to invest=11×0.6−0.4=0.2

This suggests investing 20% of your portfolio in this dividend stock.

Balancing Risk and Reward

The beauty of the Kelly Criterion lies in its balance between risk and reward. By applying this formula, you can make more informed decisions about how much to invest in each opportunity, optimizing your potential for growth while safeguarding your capital.

Warren Buffett’s success and the strategic decisions at the poker table illustrate the power of the Kelly Criterion. By incorporating this formula into your dividend investing strategy, you can approach stock picking with a clearer, more calculated mindset.

Happy investing!

Best regards,

-Ken Ku