Today we’re going deep. We’re going to examine a mathematical equation created years ago by a guy named J. L. Kelly. Kelly was a brilliant man who devised a formula that is so rudimentary, yet so critical, it is the foundation for many systems in the world of finance AND gambling. Here is the formula:
Fraction of bankroll to invest = Edge / Odds
Edge means any information you have that gives you better than 50/50 odds. For example, if you have a quarter that is weighted in such a way that heads should come up 60% of the time, then your edge would be 10%. On any one flip of the coin, you would have a 10% edge if you bet on heads. In the world of finance, an edge can be any information you receive that gives you an advantage over other investors.
Odds are odds. It is the payout from winning the bet or gamble. For instance, going back to the coin flip example, the odds would likely be 1:1, or even money. In the formula, this would just be represented as 1. If you guess the coin correctly, you would win an amount even to your bet. If the odds were 2:1, then a 2 would be used in the formula.
So using the above edge and odds in our formula gives us:
Fraction of bankroll to invest = 10% / 1, or 10%.
The formula tells you that you should invest 10% of your total bankroll on every coin flip.
If the odds were 2:1, then the formula would look like:
Fraction of bankroll to invest = 10% / 2, or 5%.
So…what does this have to do with search engine marketing? Everything.
To be as successful as possible in your search engine marketing, you need to allocate your funds to those keywords, ads, and campaigns that generate the highest return on ad spend. If you had enough information, you could use the Kelly formula to allocate your budget. If you don’t have enough information, it is still a good mental model for you to follow. Put more of your money on keywords that have proven to be most effective.
We will be discussing these types of concepts more in later blog posts. I just wanted to introduce you to Kelly and get you thinking about the process of maximizing the return on your paid search ad spend.