Use This Vegas Gambling Secret to Manage Risk

Andy Snyder|August 2, 2023

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 dangerous.

We don’t partake.

Even so, we’re fascinated by the numbers behind it. They’ve certainly guided our investment philosophy and made us a winning trader.

In fact, we’ve learned a lot from Edward Thorp – the math genius and professional gambler who turned the odds on Vegas before revolutionizing Wall Street.

He’s our kind of man – a thinker.

Even though he spent years at the blackjack table, Thorp would argue he was never a gambler. He was an investor. He put his chips down only when the odds of winning were better than the odds of losing.

Thorp won a lot.

He won so much, in fact, that he was banned from most casinos.

When Thorp put on disguises and taught others to do his work for him, Vegas changed the rules. 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 risk.

Revealing a Secret

You see, there’s a secret of the Vegas blackjack tables that applies aptly to investing.

Thorp used it to know exactly how much to bet on each hand so he’d be sure to win in the long run.

And this secret worked equally well on Wall Street. It made Thorp a mega-millionaire – he’s worth some $800 million today.

He taught it to Bill Gross and Warren Buffett. It treated them well too.

It remains a vital risk management strategy for all three.

It’s a formula called the Kelly criterion.

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 historical proportion of trades we’ve made that have led to a gain.

It’s simple to calculate.

First, we gather the results of our last 25 to 50 trades (or more) – not how much was made or lost, just whether each trade was a gain or loss.

Simply divide the number of winners by the total number of trades.

For example, if 35 out of 50 trades were winners, our “W” number would be 0.7.

From there… we need the “R.” That’s our win-loss ratio.

To get it, we simply divide the average amount gained on each winning trade by the average amount lost on each losing trade.

For example, if each win netted us an average of $500 while each loss cost us $1,000, our win-loss ratio (the “R” in our equation) would be 0.5.

The Magic Number

With just those two simple numbers, we can run the equation and get our Kelly number – 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].

Our Kelly number is 0.1, or 10%.

That means that if we continue to invest as we have in the past, the ideal percentage of our trading portfolio to devote to each trade is 10%.

Sticking to that number means we’re unlikely to 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 risking 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 to plug into the formula to get an accurate result.

Use the Kelly formula in your trading portfolio, 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.