## Monday, June 13, 2011

### Dreamtime Finance (and the Kelly Criterion)

I've been meaning to write about Kelly for a couple years and keep forgetting. Today I forget no more.
In probability theory the Kelly Criterion is a bet sizing technique used when the player has a quantifiable edge.
(When there is no edge the optimal bet size is \$0.00)

The criterion will deliver the fastest growth rate balanced by reduced risk of ruin.
You can grow your pile faster but you increase the risk of ending up broke should you, for example bet 100% of your net worth in a situation where you have anything less than a 100% chance of winning.

The criterion says bet roughly your advantage as a percentage of your current bankroll divided by the variance of the game/market/sports book etc..
Variance is the standard deviation of the game squared. In blackjack the s.d. is 1.15 so the square is 1.3225.

As blackjack is played in the U.S. the most a card counter can hope for is a 1/2% to 1% average advantage with much of that average accruing from the fact that you can get up from a negative table.
Divide by 1.3225 and you've got your bet size.

It's a tough way to grind out a living but hopefully this exercise will stop you from pulling a Leeson, betting all of Barings money and destroying the 233 year old bank.

I'll be back with more later this week.In the meantime here's a UWash paper with the formulas for equities investment.
Where most managers and traders screw up in overestimating you advantage, the math is a lot more straightforward in blackjack.

Here's Overcoming Bias:
In 1956, John Kelly introduced his “Kelly criteria” betting strategy: bet on each possible outcome in proportion to (your estimate of) that outcome’s chances of winning, regardless of the (fair) odds for betting. More generally, a Kelly rule invests in each possible asset in proportion to its expected future payout, regardless of current asset prices. For example, if you estimate land will be worth 30% of world wealth in the distant future, you put 30% of your investments into land today, regardless of today’s land prices.
It turns out that the Kelly rule is close to the optimal long run investment plan, i.e., the one that would win an evolutionary competition. The exact best strategy would consider current prices and expected future price trajectories and carefully choose investments to max expected growth, i.e., the expected log of a distant future portfolio. But Kelly’s rule is far simpler, gets better than average growth regardless of state, time, or prices, and approaches the exact best strategy as good strategies come to dominate prices. In fact:
A stock market is evolutionary stable if and only if stocks are [price] evaluated by [Kelly rule] expected relative dividends. Any other market can be invaded in the sense that there is a portfolio rule that, when introduced on the market with arbitrarily small initial wealth, increases its market share at the incumbent’s expense. (more)
(More on evolutionary finance here, here, here, here; see especially this review.) We’ve had big financial markets for at least a century. Has that been long enough for near-optimal strategies to dominate? Not remotely. John Cochrane explains just how bad things are...MORE
HT: Kedrosky@Bloomberg