What is the Kelly Criterion and how does it work?

In finance, the Kelly criteria is a mathematical formula for bet size that is widely used by investors to calculate how much money they should devote to each investment of their portfolio of assets. This strategy yields long term gains for the investors over other methods and is used by Billionaire Warren Buffet.

Formula for the Kelly Criterion

Kelly Criterion Formula

$$K\%=\frac{bp-q}{b}$$

Where −

K percent = The Kelly percentage, which is the proportion of the portfolio that will be gambled.

b = the decimal odds, which are always equal to one.

p = the chance of winning.

q = the probability of losing, which is equal to one minus the probability of winning.

Kelly Criterion Example

In the game of cricket there has 6 balls in every over and the probability of runs being scored on each ball is 50% for 4,5 or 6, while the exact number applies to an result of 1, 2, and 3.

Consider the following scenario: the batsman has a 60 percent chance of taking singles and scoring 1, 2, or 3, which means that the odds of getting 4, 5, or 6 are 40 percent. The variables will have the following result −

b = 1

p = 0.60

q = 1 – 0.60 = 0.40

In accordance with the Kelly criteria, K % = (1 – 0.60 – 0.40) / 1 = 0.20 or 20%

The formula suggests that 20% of the portfolio could be at value for 20% valuation of the bank value. Application of this formula must be done with caution as when people continue to bet despite lower percentage value, there is a high chance of losing money and going bankrupt.

Kelly's Criteria for Evaluation

Kelly criterion is a mathematical formula that is widely used by investors and gamblers to calculate how much money they should be dedicated to each investment by using a fixed percent of their assets.

It is based on the mathematical formula k percent = bp–q/b, where p and q represent the probabilities of winning and losing, respectively, and b represents the probability of winning.

Risk-averse investors are always cautious while implementing the Kelly criterion as they fear incurring significant losses. Therefore, despite the number shown by Kelly criterion there is a conservative approach while using it.

Traders and analysts have often urged individuals not to invest more than 20% of their stock market profile using this method they stand a chance to incur huge losses. While its plain mathematics that helps users, one must exercise caution and diversify their portfolio.

Who invented the Kelly Criterion?

John L. Kelly, an American scientist who worked as a researcher at AT&T's Bell Labs in New Jersey invented the Kelly Criterion in 1956. It became popular when it was picked up by the betting community and immediately started using it.

Conclusions and Recommendations

Essentially, the Kelly % informs people about how much they should diversify their portfolio. Irrespective of the tool, one should not dedicate more than 20% of their portfolio using this method. It is used by Warren Buffet.