The Kelly Criterion - Explained
What is the The Kelly Criterion?
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Table of ContentsWhat is The Kelly Criterion?How to Calculate the Kelly CriterionWhat Does the Kelly Criterion Tell You?Limitations of Using the Kelly Criterion
What is The Kelly Criterion?
The Kelly criterion is a formula used in estimating the growth of capital, it also calculates the expected value of wealth over a long period of time. The Kelly criterion was developed in 1956 by John L. Kelly, Jr and since then has been a strategy used in betting to determine the amount individuals should stake. Generally, the Kelly criterion is used to hedge risk and for money management, because it takes into account the sum staked, all possible outcomes and the probability of each outcome. Now, the kelly criterion is being used as a scientific gambling method to guarantee higher capital or wealth in betting. The goal of the Kelly criterion when used as a betting strategy is to maximize long-term growth of capital. The Kelly criterion is otherwise called Kelly bet, Kelly formula, and the Kelly strategy. When this strategy is used in betting, it is calculated as; Kelly%=W[R/(1W)] In the above formula, Kelly% refers to the percentage of capital an investor puts in a single bet or trade, W in the formula means the records of wins the trading system has while R refers to the historical win or loss ratio of the investor.
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How to Calculate the Kelly Criterion
The historical win percentage of a trading system which is often a factor for wining (W) and the historical win/loss ratio of the investor are the core components to consider when calculating the Kelly criterion. The tendency of the trade or bet to give a positive return is represented by W. To determine the loss/win ratio of investors, however, the total positive trade amounts of the investor must be divided by the total negative trading amounts.
What Does the Kelly Criterion Tell You?
After it was developed by John L. Kelly, Jr in 1956, the Kelly criterion was applied in the betting world as a strategy to determine the probability of winning and the maximum growth of capital over a period of time. Later on, the theory was applied to investing, it was used for portfolio selection in order to maximize wealth over a period of time. The Kelly criterion tells an investor how much to stake in a trade or bet. Here are some crucial components of the Kelly Criterion you should know;
- The kelly criterion is a theory that measures the long-term growth of capital.
- It was first used by gamblers in the betting industry before its application was extended to investing.
- The kelly formula helps investors to determine the optimal amount to put into a single trade. It is also helpful for gamblers as it determined the maximum amount to put in a bet.
Limitations of Using the Kelly Criterion
Despite the usefulness of the Kelly criterion or formula, it has some setbacks as it has received different criticisms. The most widely held criticism is that the effectiveness of this formula can be impeded by the constraints of an individual investor. Hence, the specific constraints of these investors can override their judgment when it comes to the optimal growth rate of capital. This constraint is a crucial factor that determines the investment decisions made by individuals regardless of the signals of the Kelly formula.