Kelly Criterion

Did you know that gambling drives investment theory?

It’s a not often talked about fact that many of the recent technological advances came about thanks to the “adult” industry. Online payments, streaming content, and the huge increase in internet bandwidth are all thanks to adult industry. Back in 2002 when I first started out in high frequency trading, the people setting up our servers wondered why we needed so many. We told them we were an adult entertainment company, and they didn’t even bat an eye. They just asked for free access…

In the same way, much of investment theory comes from gamblers. Fancy pants traders, quants, and hedge funder managers spend much of their time dealing with probability theory, which was invented to quantify games of chance.

Today, I’m going to talk about one such technique that bridges the gap between gambling and investing: the Kelly Criterion (which I usually refer to as just plain old Kelly). Kelly answers the oldest wagering question: “how much should you bet?”

In recent years it’s been picked up by the finance industry as a whole, and is simple enough that it could and should be used by all investors.

So What is This Kelly Thingamajig?

We’ve already said that the Kelly Criterion tells you how much you should bet. Note, it doesn’t make a guess at it. It’s a proven fact. (there are few caveats though).

I want to play a hypothetical game with. You place a wager, and I flip a coin (we’ll assume it’s fair and I don’t have magician fingers). If the coin comes up heads, I will pay you double your wager. For tails I keep your wager.

How much will you bet?

Before you can answer, you need more information. We …read more