Kelly Criterion
Candlefocus EditorOriginally presented in 1952 as a gambling system, Kelly Criterion outlined the optimal proportion of capital to wager on a given situation. It states that to determine the best budget to commit to an investment, one must take a ratio of the expected return on an investment and the probability of an investment failing.
The logic behind the Kelly Criterion is to maximize an individual’s wealth by taking the risk with the greatest expected return while staying away from the risk with the greatest potential to lose money.
Since then, the formula has become popular among investors and professional money managers, such as Warren Buffett and Bill Gross. Buffett supposedly used the formula to make a successful bet on Unilever in the early 1970’s. While the Kelly Criterion is most often used for investing, it can also be applied to other areas, such as sports betting.
Despite the Kelly Criterion’s successful track record, some individuals have questioned its usage in day-to-day investing, as investing is far too complex for an all-encompassing formula. Factors, such as risk tolerance and market conditions, would have an impact on the individual's decision-making process and the Kelly Criterion cannot be applied to all cases.
In addition, if someone applies the Kelly Criterion too stringently, they would end up investing a very large portion of their capital in what could be considered a risky move. This isn’t ideal, and in this case caution should be taken. As a result, some investors opt to use a modified version of the formula by cutting back the suggested amount of capital to invest.
Overall, the Kelly Criterion is a useful tool for investors and gamblers alike to maximize their potential gains and minimize their losses. However, it is important to bear in mind that the Kelly Criterion does have its limitations and cannot be applied to all cases with complete accuracy.