Economics Risk And Return Questions Medium
The Kelly criterion is a mathematical formula used to determine the optimal amount of capital to allocate to a particular investment or bet. It was developed by John L. Kelly Jr. in the 1950s and is widely used in the field of finance and gambling.
The Kelly criterion takes into account the probability of winning or losing, as well as the potential return and risk associated with the investment or bet. It aims to maximize the long-term growth rate of capital by finding the balance between risk and return.
The formula for the Kelly criterion is as follows:
f* = (bp - q) / b
Where:
- f* represents the fraction of capital to allocate to the investment or bet
- b is the net odds received on the investment or bet (the potential return divided by the initial investment)
- p is the probability of winning
- q is the probability of losing (1 - p)
By plugging in the values for b, p, and q, the formula calculates the optimal fraction of capital to allocate. If the result is positive, it suggests investing a portion of the capital, while a negative result indicates avoiding the investment.
However, it is important to note that the Kelly criterion assumes perfect knowledge of probabilities and returns, which is often not the case in real-world scenarios. Therefore, it is recommended to use the Kelly criterion as a guideline rather than a strict rule, and to consider other factors such as personal risk tolerance and diversification when making investment decisions.