Calculating investment proportions with Loss Chance

When investors discover good businesses that are undervalued, and they are ready to invest in said businesses, one question that always arise is, “How much of our portfolio proportion should be allocated to this stock?”

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When investors discover good businesses that are undervalued, and they are ready to invest in said businesses, one question that always arise is, “How much of our portfolio proportion should be allocated to this stock?”

This is a very difficult question, as it depends on investors’ experience and perspective -how big of an opportunity do they see gaining with this investment. The more confident they are, the more shares they can buy. But the general principle is to invest no les than 10% in a particular stock and no more than 50% of your portfolio. This is so that you receive good returns without being too risky.

That said, what many people don’t know is that we can use the Loss Chance value on Jitta to calculate suitable investment proportions for each stock with this equation:

Bet Sizing: = 50% – Loss Chance

For example, if Stock A has a Loss Chance at 35%, that means that we can invest at: (50% – 35%) = 15% of our portfolio.

So if you have a port worth 1 million Baht, you can invest at 150,000 Baht.

If Stock B has a Loss Chance at 20%, we can invest around 30% of our port.

This equation originated from the Kelly Criterion, which is an investment equation that is widely accepted worldwide.

The Kelly Criterion was originally created for gambling purposes: to help figure out the amount to gamble based on the probability of winning.

The Kelly Criterion’s simplified equation is this:

f = 2p – 1

Where ‘p’ is the chance of winning.

Therefore, if we have a 70% chance of winning, we will get the chance to win 7 times out of ten. So the amounts of money to put down in each round are the following:

f = 2p – 1

f = 2*(0.7) – 1

f = 1.4 – 1

f = 0.4 = 40%

So in this case, we shocks invest 40% of our money each time, in order to maximize our return in the long-run.

When this equation has been applied to investing, it was altered to become the Half Kelly Criterion, to reduce the investment risk, as most investments tend to come with overconfidence that make us feel that we have a higher chance of winning than we actually do.

For example, we may think that we have an 80% chance of winning and so calculate that our investment should be 60% of our port, when in reality, if our chance of winning was at 70%, we will have only 40% of our port to invest. If we invest too much and it ended up being a mistake, our port can be severely damaged.

Therefore, Half Kelly helps decrease the risk by half by dividing the figure calculated from the Kelly Criterion by 2.

So if we believe that we have an 80% chance of winning and invest 60% of our port according to the criterion, we should lessen our risk by using the Half Kelly, which is 30%, thus minimizing the risk that comes with overconfidence.

The Half Kelly is the Kelly Criterion divided by 2.

hf = f/2 = (2p – 1)/2

hf = p – 1/2

hf = p – 0.5

Remember that ‘p’ is the chance of winning; so if our chance of winning is 70%, that means that our chance of losing will be 30% (100 ,minus 70). Let’s use ‘q’ for our chance of losing; therefore, p = (1 – q)

If we substitute p = (1 – q) into Half Kelly, we will get:

hf = p – 0.5

hf = 1 – q – 0.5

hf = 0.5 – q

Now it probably clicks: ‘q’ (or the chance of losing) is Loss Chance on Jitta.

So this is the origin of our investment equation on Jitta, using Loss Chance to assist in the calculation. Here’s to compare it with theHalf Kelly Criterion again:

Bet Sizing = 50% – Loss Chance

This is one simple way to help us quickly determine the suitable amount of money to invest in each stock,and then we can adjust it based on our experiences in investing.

And of course, this equation has shown us that the stocks we should be investing in should have a Loss Chance value of no more than 40%, so that we can invest in the stock for at least 10% of our port, which is what Peter Lynch and Warren Buffet have preached.

In conclusion, Jitta not only helps us to easily find “great companies with reasonable prices” with Jitta Score and Jitta Line, but also helps us to effectively and efficiently allocate our investment capital in each company by using Loss Chance.

Hopefully, you guys will love using LossChance as much as you love the Jitta Score and Jitta Line!

If you want to further look into certain topics, please do so via the links below:

Kelly Criterion : http://en.wikipedia.org/wiki/Kelly_criterion

Jitta Loss Chance : How is Loss Chance Beneficial?

Asset Allocation : Jitta Portfolio Series # 2

Author: Jitta

Jitta simplifies financial analysis for value investors and financial advisors alike. Our stock-analysis platform offers actionable advice to help them make better investment decisions and generate higher returns based on a simple principle: “Buy a wonderful company at a fair price.” And we do that by creating Jitta Ranking, our proprietary algorithm that ranks stocks based on their profit potential. Returns generated by Jitta Ranking since 2009 has outpaced that produced by the S&P500 index by a large margin. Jitta’s technology processes information like a human mind, assessing complicated data and digesting it into an easy-to-use and intuitive format. Its key features include Jitta Score, an indicator of a wonderful company; Jitta Line, an indicator of a company's fair price; financial statements-made-simple Jitta FactSheet; Jitta Playlist, an intelligent screener and backtest system in one; and Jitta Portfolio, a smarter investment-tracking mechanism.

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