Table of Contents
- What Is the Kelly Criterion?
- Key Takeaways
- Understanding the Kelly Criterion Formula and Its Applications
- Warning
- Recognizing the Limitations of the Kelly Criterion
- How Do Investors Find Their Win Probability With the Kelly Criterion?
- How Do Investors Input Odds Into the Kelly Criterion?
- How Are the Black-Scholes Model and the Kelly Criterion Related?
- Key Insights into the Kelly Criterion
What Is the Kelly Criterion?
Let me introduce you to the Kelly Criterion. John L. Kelly Jr. developed this formula back in 1956 while working at AT&T's Bell Laboratories. It's designed to help you figure out exactly how much of your capital to invest in a particular asset to maximize your wealth growth over the long term.
Key Takeaways
The Kelly Criterion is a straightforward formula from 1956 by John L. Kelly Jr. that guides you on optimal investment sizes for wealth maximization. It started in gambling to calculate bet sizes based on win probability and win/loss ratios. Remember, it's great for sizing investments but doesn't handle portfolio diversification on its own. Some economists point out that personal constraints can make it less effective for real-world growth.
Understanding the Kelly Criterion Formula and Its Applications
Gamblers first picked up the Kelly Criterion in 1956 for horse racing bets, and later, big names like Warren Buffett and Bill Gross applied it to investing. The formula tells you the ideal amount to put into a trade. It boils down to two components: the winning probability factor (W), which is the chance a trade yields a positive return, and the win/loss ratio (R), calculated as total positive trade amounts divided by total negative ones.
The output gives you the percentage of your total capital to allocate to each investment. You might hear it called the Kelly strategy, formula, or bet. Here's the formula: Kelly % = W - [(1 - W) / R], where Kelly % is the percent of your capital for a single trade, W is your historical win percentage, and R is your historical win/loss ratio.
Warning
The Kelly Criterion has its uses, but you need to factor in diversification. I advise caution if you're tempted to pour everything into one asset, even if the formula shows high success odds.
Recognizing the Limitations of the Kelly Criterion
Even though it's appealing, some economists argue the Kelly Criterion isn't always the best because personal investment limits can hinder growth. In practice, your own constraints—whether you set them or not—play a big role in decisions. Consider Expected Utility Theory as an alternative; it focuses on maximizing expected benefits from bets.
How Do Investors Find Their Win Probability With the Kelly Criterion?
If you're using the Kelly Criterion, estimate your win probability by reviewing your last 50 or 60 trades and counting the positive returns.
How Do Investors Input Odds Into the Kelly Criterion?
To plug in odds, determine W (probability of a favorable return) and R (average win size divided by average loss size). Use your recent returns for estimates, then input into the formula: K = W - (1 - W) / R, where K is the percentage of your bankroll to invest.
How Are the Black-Scholes Model and the Kelly Criterion Related?
Both the Black-Scholes Model and Kelly Criterion are math-based systems for estimating returns with uncertain variables. Black-Scholes prices options based on maturity and other factors, while Kelly focuses on optimal investment size using win/loss probabilities.
Key Insights into the Kelly Criterion
The Kelly Criterion is a formula to maximize your wealth by allocating the right amount of capital per trade, using positive return probability and win/loss ratio. Developed by John L. Kelly Jr., it offers precise suggestions, but you must balance it with diversification and your personal limits. Apply it carefully, especially for individual trades—it's insightful but not foolproof.
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