Comment by hodder

4 years ago

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.

    • I would be surprised and perhaps a little disappointed if any professional investors think of E log X optimisation as the latter.

      1 reply →

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.

  • 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.

    • “ The fundamental principle of Kelly is that you know your edge, in the markets that is mostly untrue.” Most every professional investor I’ve met attempts to quantify the risk-reward of each trade and size accordingly. I agree that naieve investors engage in false precision eg assuming backtest sharpe for position sizing, or ignoring correlated risks. That makes them size too aggressively. But that doesn’t mean pros don’t try their best to estimate risk reward and size accordingly. Indeed many of the best traders ever (Buffett, Soros) put on massive bets when the risk reward were highly in their favor.

      2 replies →

    • > It is important to understand how a tool works at a practical level.

      There needs to be a term for "This page you're reading is bogus horseshit theory, do not try to apply it practically".

      1 reply →