Investment Theory #6: Buffett’s 1962 Letter

In 1956, Warren Buffett concluded his work for Benjamin Graham and returned to Omaha, where he started an investment partnership. This partnership was formed with seven limited partners, made up of family and friends, contributing $105,000, and Warren Buffet contributing $100. Over time it grew.

This post continues my series about that partnership. The goal is to gain some insight into one of the most successful investment vehicles in modern history.

Links to past years can be found here: 1957, 1958, 1959, 1960, 1961

Numeracy #6: Kelly Criterion

Imagine we are given the opportunity to bet on a fair coin flip. If heads, we get 2 dollars for every dollar bet. If tails, we lose our bet. We can easily work out the expected value of a 1 dollar bet.

EV = 0.5($2) – 10.5($1)
EV = $0.50

On average, we can expect to make 50 cents per bet. How could we possibly lose? Now, imagine that we have a bankroll (investable capital) of 10 dollars. We take our 10 dollars, bet it all on heads, and lose it all. We broke the first rule of gambling, don’t get wiped out.

The solution seems obvious: never bet your whole bankroll. But how much should we bet? 9 dollars, 7 dollars, 4 dollars, 0 dollars? This is where the Kelly Criterion comes into play. The Kelly Criterion, or Kelly Optimization Model, is a formula used for determining the optimal size of a series of bets. It other words, it tell us how much of our bankroll to bet given a chance of winning and a payout.

Analysis: Alliance Resource Partners LP

Introduction and Disclaimer

This document contains an independent analysis of Alliance Resource Partners LP (NASDAQ: ARLP). Information on my investment philosophy can be found here.