After looking over my last post on the 80/20 rule and also having a discussion with a fellow trader, I’ve decided to write this short post in order to add one more angle to the 80/20 rule, and more specifically, how it relates to – to what I found to be – the best staking staking system and namely the Kelly criterion.
I will not go in full details on the Kelly system, but for those of you who are not familiar, here it is in a nutshell. Your stakes – or the risk you take – are in direct proportion to the probability of your bet or outcome, happening. So the higher the probability, the higher your risk should be and on the flip side, if your probability is low, your stake or the risk you take, should be adjusted accordingly. Or in other words, the higher the value or edge you have the higher the percentage of your total bankroll that you should commit, and if there is no value or edge then there is no bet.
Now, how does this fit in with the 80/20 rule ?
In the 80/20 post I talked about how you should focus and invest more time and resources in the 20% of the trades that bring in 80% of the profits. By doing so, you will manage to make more money while trading less and become a more effective and efficient trader.
The Kelly criterion fits into this scheme perfectly, because applying Kelly, you want to use the “right” percentage of your total bankroll for each individual trade, that will enable you to have the highest possible return on your bankroll or achieve the optimal growth rate. You want to increase the returns on those 20% of the traders, since your records clearly indicate that those are the trades that have the most value and edge.
This works for trading, investing or sports betting.
Probably the most popular applicant of Kelly is the US billionaire Warren Buffet. In 1992 Buffet was quoted on stock diversification.
Many pundits would therefore say the [this] strategy must be riskier than that employed by more conventional investors. We disagree. We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it.
He might be referring to stocks, but it can easily be related to the trading activities of a sports trader.
By using the 80/20 rule, you have analyzed your past trading records and know where those 20% of the trades come from and you want to stake or risk more on those traders. Why would you want to diversify or spend more time on trades that do not bring in the same amount of profits? But as in the previous post, for this to be implemented, you have to have past records for analysis and also to be profitable, this meaning that you have an edge to start with.
Also keep in mind that Kelly can be to risky for some, and that is why most trader I know use a half Kelly as an extra measure of caution.
As always, if you have any questions or something to add, you can leave them in the comments section below.