Kelly Criterion

QUOTE

Robert Arnott once said…

“In investing, what is comfortable is rarely profi.”

(American businessman, investor, and writer.)

CONCEPT

Kelly Criterion

The Kelly Criterion is a mathematical formula used to determine the optimal size of a series of bets in order to maximize long-term growth of capital.

Developed by John L. Kelly Jr. in 1956, the criterion takes into account both the probability of winning and the potential payoff, aiming to strike a balance between risk and reward.

STORY

Math Makes … Money!

In the smoky backrooms of Las Vegas casinos, a group of blackjack players gathered in the 1950s to unravel the mysteries of gambling. Among them was John L. Kelly Jr., a young physicist with a penchant for numbers and a keen interest in probability theory.

Fascinated by the allure of blackjack and the challenge of beating the house, Kelly embarked on a quest to develop a strategy that would give players an edge in the high-stakes world of gambling.

Drawing upon his background in mathematics and information theory, Kelly devised a groundbreaking formula that would forever change the way players approached the game.

Kelly's breakthrough came in the form of the Kelly Criterion—a mathematical formula designed to optimize the size of bets in order to maximize long-term growth of capital. Unlike traditional gambling strategies that focused solely on maximizing short-term gains, the Kelly Criterion took into account both the probability of winning and the potential payoff, aiming to strike a delicate balance between risk and reward.

For the mathematically minded, the Kelly Criterion advises bettors to bet a fraction of their bankroll equal to the difference between the expected return on the bet and the probability of losing, divided by the odds. (Don’t worry if that didn’t make a whole lot of sense.)

The key insight behind the Kelly Criterion lay in its ability to adapt dynamically to changing circumstances, allowing players to adjust their bets based on the strength of their edge in each hand. By allocating a portion of their capital proportional to their advantage, players could minimize the risk of ruin while maximizing their expected return over time.

Armed with the Kelly Criterion, blackjack players gained a powerful tool for managing risk and enhancing returns in the casino. No longer beholden to hunches or gut feelings, players could approach the game with a systematic, data-driven approach that tilted the odds in their favor.

Kelly's revolutionary insight didn't just apply to the world of gambling—it also had profound implications for investing and finance. The same principles that guided players at the blackjack table could be applied to the stock market, helping investors manage risk and optimize returns in their portfolios.

Today, the Kelly Criterion remains a cornerstone of modern finance, guiding investors and gamblers alike in their quest for profitable outcomes.

Whether at the blackjack table or in the stock market, the principles of risk management and capital allocation embodied by the Kelly Criterion continue to shape the way we approach uncertainty and opportunity in the pursuit of wealth and success.