What James Holzhauer Teaches Us About Optimal Capital Allocation
James Holzhauer is currently in an unprecedented run on the game show, Jeopardy. He has broken many records so far, and he is going for the highest cumulative prize money haul in the history of the show. He already has won $1.69 million dollars as of this writing.
He plays with one goal: maximize his total winnings.
It turns out that a rational investor has identical goal in his investing.
It also turns out that investing and Jeopardy have similar attributes and allow for similar approaches for success.
How is Investing Similar to Jeopardy?
Successful investing is not a random walk. Neither is playing on Jeopardy. Both require certain skill, and an acute awareness of one’s own level of skills. You need to know what you can handle, and where you enter into the realm speculation.
On a tactical level, in Jeopardy, you can choose the answers you want to question. Similarly, in investing, you can choose the stocks you want to invest in. In either pursuit, you are not required to make a pick. You can choose to sit out every round if you wish (but this will hardly be productive).
So you need to choose wisely.
For if you choose correctly, you make money. If you are wrong, you lose money. The amount of money you win or lose depends on how much of your “portfolio” you allocate to each “pick”.
Therefore, in either discipline, the strategies eventually boil down to one of the two: longevity, and/or, maximizing profits in each play.
The Strategy of Longevity
The goal here is to put in a long streak of wins. The profits add up over time, so if you can add time to your kitty, you will come out very wealthy.
In investing, you can do this by investing in a well diversified portfolio. This is the same as investing in an index fund or ETF. You will have a number of wrong picks, but you will also have a number of good picks. The goal is to offset good with bad, and then hope that the resulting portfolio returns are good enough to keep you ticking for a long time.
For a Jeopardy player, this is akin to having knowledge of a wide variety of topics. You may not know any of the topics in any significant depth, but what you lack in depth, you make up in breadth. In many cases, this works well over time.
The Strategy of Maximizing Profits
The goal here is to accumulate as much winnings you can, as rapidly as possible.
The way to do this is to bet large, so when you win, you win large.
However, crucial to the success of this strategy is to make sure that you either do not lose, or when you do, you lose small amounts of money.
A Jeopardy player, for example, could bet smaller amounts in the topics he is not very confident about, or none at all. He can bet larger amounts in the topics he is very confident.
Depth of knowledge helps a lot. At the same time, the player needs to be aware where his strengths and weaknesses lie. He needs to know his past performance in a variety of situations so he can make intelligent decisions in the future plays.
An investor will do the same. He will refuse to invest in a stock where he does not possess enough conviction. In the stocks where he has deep conviction, he may choose to go all in and allocate a large portion of his portfolio.
James Holzhauer plays to maximize profits. This is evident when you watch him in the show.
Let’s see how his strategy transfers over to investing.
Investment Strategy to Maximize Profits
This requires the following 3 sub goals.
- Bet big in high conviction cases
- Bet small or refuse to play in low conviction cases
- Prioritize cases with highest potential rewards first
In Jeopardy, Daily Doubles pay more if you get them right. Unlike most Jeopardy players who like to start with smaller reward picks, James goes straight for the highest point picks. There are 2 reasons – 1. The winnings are large, and 2. Quick accumulation helps give you more options later on if you wish to sit out questions that you are not very confident about.
Can an investor do this?
Absolutely.
Warren Buffett likes to talk about a baseball game where you are the batter and you are facing pitch after pitch.
“The trick in investing is just to sit there and watch pitch after pitch go by and wait for the one right in your sweet spot. And if people are yelling, ‘Swing, you bum!,’ ignore them.”
When you get a pitch in your sweet spot, swing hard.
When you are comparing two or more investment to allocate capital in, choose the one that will give you the best rewards.
The Complication in this Strategy
As you might have guessed, this strategy only works if you know the following two things.
- Where is your sweet spot?. and,
- What is your potential reward?
Let’s consider these two things one at a time.
Where is Your Sweet Spot?
Some people call this your circle of competence. In business, it is often called “core competency”. It doesn’t need to be a particular industry or a type of a company, although you can certainly build your circle of competence around these. It could also be in style of investing – for example, distressed debt investing, or investing in cyclical stocks.
As value investors, you may emphasize cash flow while another investor may be more focused on tangible assets. Whatever your circle of competency is, you need to know what it is, and then stick to it.
How do you know your circle of competency or sweet spot?
Mostly by experience. You can look back, either intentionally, or instinctively, and know that some kinds of investments work out better for you than others. Emphasize what works, and eliminate what doesn’t work.
If you are unsure, or are trying to expand your sweet spot to include newer areas, require a sufficient margin of safety to give you the buffer to make mistakes. Over time you will learn and become proficient.
What is Your Potential Reward?
You could do this one of the two ways.
a. You can fix a minimum potential return that will interest you in a new investment. Let’s say you decide that a 30% potential annual return is what you need at the minimum. Then you will eliminate all those investment ideas where the potential return does not rise above this threshold.
b. Or you could calculate your potential reward from each idea and have a process to determine how much of your capital to allocate to each idea.
b. is where most money is made. Higher potential reward ideas receive larger bets. And you have a process to figure out the potential rewards. This could be based on any process that you have found success in in the past. For me, many value investing principles let me estimate an intrinsic value or fair value of the stock. The gap between the current market value, and the intrinsic value, tells me the potential reward.
Most investors make mistakes. Some make more mistakes and others make less. Once you calculate the potential rewards, you need to modify with your past win/loss performance, to give you a more realistic expectation of winnings.
As you can imagine, the math can quickly become complicated. It is hard enough to estimate the merits of the investment, but you also need to know your own self, and your investment biases, and adjust your expectations based on these. James has a very good grasp of this and an intuitive sense of his strengths and weaknesses and he can work out the probabilities very quickly in his mind. His professional career as a sports bettor helps.
Fortunately, someone already did the calculations to figure out the optimal capital allocation formula, that you can use to invest and maximize your wealth growth. Kelly Criterion was formulated by John Kelly of Bell Labs and gives you the absolute optimal capital allocation system to maximize your portfolio growth. Learn about the Kelly Formula here.
I lied. You need one more thing to make this work …
The formula only works when you stick to it. In the beginning, a lot of parameters may not be defined well for you. Over time, you will get more accurate. However, you need to stick it out and disconnect yourself from the emotional aspects of investing.
If you do not think you can muster up the objectivity, discipline and persistence to make this work, an index fund is your best friend.
This article originally appeared on Value Stock Guide
Learn more about Value Stock Guide investment process here.