You may spend hours finding the right stock to buy or to sell short. If you beat the market, you’ve got alpha. In a past newsletter, I have asked readers a question, asking for answers by e-mail. Here is the question:

Suppose we have a coin toss, with a perfectly normal coin and a non-professional flipper, so the odds are fifty-fifty that it will land on heads or tails each time.

Let’s say you always bet heads, and for each dollar you bet, when the coin lands on heads (fifty percent of the time long term), you make two dollars; if it lands on tails, you lose one dollar. So you have an edge of one third in your favor; let’s also assume you have a hundred dollar account. Now the question: if you wish to maximize your payout in this game, what percentage of your total account should you bet on each flip?

A. 10 %
B. 25 %
C. 40 %
D. 51 %

A majority of you have answered c. 40%, and b. 25% came in second.

Here are the payouts that you can expect from following each money management strategy:

A. If you bet 10% each time, your probable payout after 100 flips will be $4,700
B. If you bet 25% each time, your probable payout after 100 flips will be $36,100
C. If you bet 40% each time, your probable payout after 100 flips will be $4,700
D. If you bet 51% each time, your probable payout after 100 flips will be $31

In other words, depending on which money management strategy you choose, you can make 1’161 times more money than if you have the wrong approach.

What does that mean for the average investor? And, more importantly, how can you apply this today for your own profit?

First of all, you need to recognize that, if you don’t currently use a mathematical formula, understanding its implications, you may be making 1’161 times less money than you could with the right approach.

So how can you proceed? My advice is to use the Kelly formula. This is how it goes, in a nutshell. First, find out the following statistics:

How much you win when you win (in the above example: 2)
How much you lose when you lose (in the example: 1)
What your probable chance of losing is (here: 50%)
What your probable chance of winning is (here: 50%)

Take the first number and divide it by the second. Here: 2 divided by 1 = 2.

Then, take the third number and divide it by the result above. 50% divided by 2 = 25%.

Finally, take the fourth number and subtract by the last result. 50% minus 25% equals 25%. This is the amount that you should risk on each bet in our example, if you want to minimize your probable payout.

Note that there is still a 6.25% chance for you to go bankrupt after the fourth coin toss, so nothing is perfect.

We ran the numbers on the Inside ALPHA strategy, and the optimal amount of one’s money to allocate to it is 37.67%, according to the formula. To be on the safe side, we prefer to encourage investors to risk less than that in any single strategy, including ours.

Just for the fun of it, I also did the calculation for a buy and hold strategy on the S&P 500 index. Amount to allocate to this strategy, according to Kelly: 1.76%

Don’t say we didn’t warn you…

TAKE AWAY POINTS TO CONSIDER:

Get your calculator out and do the math

Use the Kelly formula determine what portion of your assets should be invested in any given portfolio Keep in mind that any strategy can go bankrupt at any time... protect yourself by diversifying

Good luck and warm regards,

Marc Mayor

"Double your money with half the risk"

http://www.inside-alpha.com/presentation.html