Secrets of the Vegas Insider Who Mentored Warren Buffett and Bill Gross
Editor’s Note: A version of this piece originally ran in Andy Snyder’s free e-letter, Manward Digest.
It’s one of the most common questions we get. Readers often write us and ask how much money they should devote to each trade.
Below is the Vegas secret that I share with my Manward Digest readers.
To be clear, we have a moral issue with gambling. After all, one of our core beliefs is that wealth leads to Liberty. Therefore gambling leads to slavery.
It’s a dangerous game.
We don’t partake.
Even so, we’re fascinated by the numbers behind it all. They’ve certainly guided our investment philosophy.
One man – an infamous Vegas insider – has taught us a lot.
Edward Thorp is the math genius and professional gambler who turned the odds on Vegas and then revolutionized Wall Street.
He’s a Manward kind of man – a thinker.
Even though he spent years in the blackjack game, Thorp would argue he’s not a gambler. He’s an investor. He put down his chips only when the odds of winning were better than the odds of losing.
Thorp won a lot.
He won so much, he was kicked out of most casinos.
When Thorp put on disguises and taught others to do his work for him, Vegas changed the rules. Then, with the math no longer in his favor, he took his skills to Wall Street.
It was a move that benefited us all… especially when it comes to managing our risk.
Revealing a Secret
You see, there’s a secret of the Vegas blackjack tables that aptly applies to investing.
Thorp used it to know exactly how much to bet on each hand so he’d be sure to end up a winner.
But it worked equally well on Wall Street as a tool to determine how much to invest in each position. It made Thorp a near billionaire – worth some $800 million today.
He taught it to Bill Gross (who Thorp mentored) and Warren Buffett. From what we hear, it treated them well, too.
All three still use this vital risk-management strategy.
It’s a formula called the Kelly criterion, and it spits out the percentage of your portfolio that you should devote to one trade.
It looks like this: Kelly % = W – [(1 – W) / R].
We need just two important pieces of data to crunch the numbers.
First, we need our win probability – the “W” in the equation above. That’s the historic proportion of trades we’ve made that have led to a gain.
It’s simple to calculate.
First, we gather the results of at least our last 25 to 50 trades – not the dollars made or the percentages lost, just whether they were gains or losses.
Simply divide the number of positive trades by the total number of trades.
For example, if 35 out of 50 trades were wins, our “W” number would be 0.7.
From there… we need the “R.” That’s our win-loss ratio.
To get it, simply divide the average dollars gained on each winning trade by the average loss on each losing trade.
For example, if each win nets us an average of $500, while each loss costs us $1,000, our win-loss ratio (the “R” in our equation) is 0.5.
The Magic Number
With just those two simple numbers, we run the equation and get our Kelly percentage – the percentage of our overall portfolio we should devote to each trade.
Using our example above, the formula looks like this: Kelly % = 0.7 – [(1 – 0.7) / 0.5] = 0.1.
Our Kelly number is 10%.
That means, if we continue to invest as we have in the past, we should devote 10% of our trading portfolio to each trade.
Sticking to that number ensures that we won’t run out of money before we make significant gains. It virtually eliminates the threat of a losing streak wiping us out.
In other words, the Kelly criterion ensures we are appropriately diversified.
Of course, we’re not talking about our nest egg. The key to this formula is that it is only for our trading portfolio – it’s not to be used for a set-it-and-forget-it portfolio. After all, we wouldn’t have enough data from a long-term portfolio to accurately enter into the equation.
Use the Kelly formula with your play money, and you’ll quickly see its value. It will greatly lower your overall risk.
It’s a Vegas secret that works even better on Wall Street.
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About Andy Snyder
Andy Snyder is the founder of Manward Press, the nation’s premier source of unfiltered, unorthodox views on money and what it means for a free society. An American author, investor and serial entrepreneur, Andy cut his teeth at an esteemed financial firm with nearly $100 billion in assets under management. Andy and his ideas have been featured on Fox News, on countless radio stations, and in numerous print and online outlets. He’s been a keynote speaker and panelist at events all over the world, from four-star ballrooms to Senate hearing rooms. Today, Andy’s dissident thoughts on life, liberty and investing can be found in his popular daily newsletter, Manward Digest.