Comment by a11r
4 years ago
For anyone actively managing investment portfolios, a deep understanding of the Kelley criterion is very important. For example, it is common practice to use "Half Kelly" to size positions, but most sources only provide a hand-wavey intuitive explanation. Thorp's paper[2] quantifies the benefits for any fraction of the "full Kelly" bet and its implications. In addition to Poundstone's book [1] I strongly recommend Ed Thorp's highly readable paper[2].
[1] Poundstone, William (2005), Fortune's Formula: The Untold Story of the Scientific Betting System That Beat the Casinos and Wall Street, [2]https://wayback.archive-it.org/all/20090320125959/http://www...
Understanding Kelly criterion is almost useless in practical investment management. I’m a professional trader and former quant and I don’t know a single actual pro who uses anything like Kelly to size bets. I’m not saying understanding the methodology isn’t commonplace and useful, I’m saying this isn’t how portfolios are structured in the real world. Securities are not like a deck of cards.
This seems to be discussed at greater length among retail traders who have no way of even knowing their odds than any professional.
I don't have the source at hand but by looking at what data we have from successful investors, many of them have returns that statistically seem like what you'd expect from E log X strategies.
In fact, it's not even a point of debate. If you target growth, you are using the Kelly criterion whether you know it or not. It's just the name for the thing you do when you optimise for growth.
There are kind of two main points by Kelly:
1. Investment returns are multiplicative and should be looked at as a geometric series. To optimize the portfolio, optimize for geometric mean not arithmetic mean.
2. To optimize the geometric mean of some specific games, apply some specific mathematical rules that Kelly derived.
Then 2nd part is not applicable to general market investing. The 1st part is.
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Kelly can work if you can properly model your uncertainty over the probability of outcomes and take this into account. You can either do some sort of Bayesian averaging over your posterior belief of the risk, or you can use the pessimistic side of the confidence interval of the actual risk probability.
The key understanding of the Kelly Criterion is that you need to scale your investment size with risk; riskier investments require smaller investments. How you estimate risk and how that informs your investments is rather fluid, but understanding it is the cornerstone of professional investing.
If you don't understand that, then you are going to go eventually go bust.
https://blog.alphatheory.com/2013/01/kelly-criterion-in-prac...
From the second article[2] that follows: “This makes sense because the problem with the Kelly Formula for portfolio management is that it looks at each bet individually” i.e. the Kelly Criterion bets your whole portfolio on a single position. I presume any strategy that has multiple positions (a portfolio) cannot use the Kelly Criterion by definition.
[2] https://blog.alphatheory.com/2013/01/kelly-criterion-in-prac...
[0] https://alphatheory.zendesk.com/hc/en-us/articles/3600356960... has an explanation of the “Alpha Theory” which I couldn’t quickly find on the alpha theory site.
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A tiny firm managing under $100m uses Kelly...and...
The post you replied to is right. The fundamental principle of Kelly is that you know your edge, in the markets that is mostly untrue. Funds will volatility-weight their portfolio but this isn't the same as Kelly in practice. Most fund managers will also weight their portfolio towards their "best" position but that is not necessarily based on return. Indeed, picking high return assets is only half the battle.
I also bet a lot, so I am familiar with Kelly. It is totally unusable in finance, no-one uses it in finance, and retail investors have an obsession with it.
In particular, if you Kelly-weight a value portfolio (which the firm linked to in your post is) then you are setting cash on fire. And if you Kelly-weight a long/short portfolio (again, the firm linked to appears to be doing this) then you are setting cash on fire. It is important to understand how a tool works at a practical level.
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Second this. Nobody actually uses it. It's a bit too theoretical.
For any kind of trading activity, the most important skill to have is risk management. You can get everything else completely wrong, but if you have your risk management down you're still in the game and can learn from your mistakes. If you don't you're liable to be ruined and be out of the game until you can build back a bankroll some other way.
Ed Thorp AND Claude Shannon! One of the best nontechnical finance books ever written.
In practice though, positioning doesn’t work like that in modern times because a lot of your entries and exits happen around liquidity events. However, it is very pertinent for biotech stocks and special situations where you are dealing with discrete outcomes.