Hi Valuepickrs,
Dinesh Sairam here once again, with… you guessed it… another excel model. This time, it’s not so much realted to Valuing stocks, but towards the elusive concept of Capital Allocation.
Kelly Criterion
The idea behind the model is completely owed to Dr. J. L. Kelly Jr., the author behind the famous paper “A New Interpretation of Information Rate”, which gave us an interesting way to think about bets in a wagering game. In short, ‘Kelly Criterion’ is a formula which calculates how much of one’s wealth can be put down in a bet in order to maximize the rate of return.
Over the last few weeks, I happened to go through the paper, while also accessing a few other websites on the topic. So, today, I decided to make an excel model based on ‘Kelly Criterion’, that can be used as a Capital Allocation Framework for investors.
The Model
Feel free to download the model using this link: Kelly Criterion Capital Allocator.xlsx (15.8 KB)
In case you have a hard time finding out the ‘Expected Returns’ on your investments, you may also need my other model to make things easier: Practical Thought Valuation Model.xlsx (14.8 KB)
This is how the ‘Kelly Criterion Capital Allocator’ looks like inside:
(The details I have entered currently are just fillers)
Notes
The model is pretty much self-explanatory. But let me leave a few notes on how to use it / how it works:
- Editing/Changing: Edit/Change ONLY the cells highlighted in yellow. Editing anything else in the model may cause it to malfunction or break permanently.
- Transitioning: You can enter ‘Current Capital Allocation’ as a Percentage or Number. But while transitioning between the two, you may see weird calculations happen i.e. If you entered ‘Rs. 10,000’ in the first column of ‘Current Capital Allocation’ and then transitioned to ‘Current Capital Allocation (%)’, the excel will likely convert it directly to 10,00,000% or so. The easy fix is to just re-enter the figures appropriately.
- Errors: The most common error I can think of is you enter figures that don’t add up. Ex: Entering ‘Rs, 10,000’ as the total Capital value, but then the sum of each security’s value as more than Rs. 10,000 and so on. The fix is to not to do such mistakes.
- Interpretation: The ‘Kelly Criteria’ column shows how much you can bet individually on each security. ‘Expected Capital Allocation’, of course, re-allocates the bets at the Portfolio level.
- Sharing: Like most of my models, there are no restrictions in sharing this one around. But I only request that you do not remove/hide the attribution written below. We owe at least this much to Dr. J. L. Kelly Jr.
References
Of course, ‘Kelly Criterion’ has both pros and cons. For an easier understanding, kindly refer to Wikipedia or FinBox.
P.S. The Theory of Capital Allocation
If you’re usually fed up by looking at numbers alone, fret not. The theory of Capital Allocation has been discussed at length in VP already. I suggest you visit the following thread, which is nothing short of a must-read if you use this forum regularly. If you can make an association between the theory and the numbers behind Capital Allocation, that would be amazing.
Please do use the model and post the results. Any and every criticism will be taken at face value. We’re here to learn and what better way than through a constructive dialogue?