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.
From what I can tell “Kelly Criterion” originally applied to one bankroll and a single repeated bet.
It seems the choosing the optimal strategy for allocating a portfolio to maximise growth is often called “Kelly style”, “Kelly strategies”, “Kelly methods”, and also “Kelly criterion” by some people (which is why I was confused).
The details of an optimal strategy are completely different depending upon your assumptions (how reallocation is performed as new information is received, accounting for error in predicted outcomes, blah blah blah) so there cannot be a single definition for the Kelly Criterion for a portfolio, instead there are a variety of strategies (each with different assumptions and constraints).
For example the “many assets” model you refer to looks like it models a single market correlation (alpha), and not the multiple correlations within a real market.
Disclaimer: I am not an investment professional, but a small amount of software experience with hedge fund NAV calculations.
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.
When I place a bet, I can estimate my edge because the outcome is binary. When the outcome is continuous, it is far more tricky. It is like saying a kid who learns to ride his trike is ready for MotoGP...they are just totally different.
And yes Soros put on big bets, but what you are missing with Soros is the fact that his hit rate was still 30%. Most of the stuff he did didn't work out, macro is largely bets on skewness not returns. Buffett had a higher hit rate but trying to suggest someone optimise a strategy based on what literally the best investor of all time did is...not smart. Even if you were better than Buffett, you might not be lucky.
The reason why Kelly doesn't work with value investing in particular is because your returns are largely random, you know that your portfolio has an edge but you don't usually know which position is going to revalue.
The reason why Kelly doesn't work with long-short in particular is because you aren't only betting on return but correlation. Anyone who runs Kelly will eventually get a correlation spike and blow up (this is also roughly true of macro, again why Soros isn't a good example, he largely bet on skewness).
I was a "pro" so I am also aware of what most pros do. Again, investors don't only look at return, they have to look at correlation, volatility (note that if you are betting on sports, you don't have to worry about things like correlation).
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.
Take a look at the "Many Assets" subheading in the original post.
From what I can tell “Kelly Criterion” originally applied to one bankroll and a single repeated bet.
It seems the choosing the optimal strategy for allocating a portfolio to maximise growth is often called “Kelly style”, “Kelly strategies”, “Kelly methods”, and also “Kelly criterion” by some people (which is why I was confused).
The details of an optimal strategy are completely different depending upon your assumptions (how reallocation is performed as new information is received, accounting for error in predicted outcomes, blah blah blah) so there cannot be a single definition for the Kelly Criterion for a portfolio, instead there are a variety of strategies (each with different assumptions and constraints).
For example the “many assets” model you refer to looks like it models a single market correlation (alpha), and not the multiple correlations within a real market.
Disclaimer: I am not an investment professional, but a small amount of software experience with hedge fund NAV calculations.
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.
Correct. That is the gap in understanding here.
When I place a bet, I can estimate my edge because the outcome is binary. When the outcome is continuous, it is far more tricky. It is like saying a kid who learns to ride his trike is ready for MotoGP...they are just totally different.
And yes Soros put on big bets, but what you are missing with Soros is the fact that his hit rate was still 30%. Most of the stuff he did didn't work out, macro is largely bets on skewness not returns. Buffett had a higher hit rate but trying to suggest someone optimise a strategy based on what literally the best investor of all time did is...not smart. Even if you were better than Buffett, you might not be lucky.
The reason why Kelly doesn't work with value investing in particular is because your returns are largely random, you know that your portfolio has an edge but you don't usually know which position is going to revalue.
The reason why Kelly doesn't work with long-short in particular is because you aren't only betting on return but correlation. Anyone who runs Kelly will eventually get a correlation spike and blow up (this is also roughly true of macro, again why Soros isn't a good example, he largely bet on skewness).
I was a "pro" so I am also aware of what most pros do. Again, investors don't only look at return, they have to look at correlation, volatility (note that if you are betting on sports, you don't have to worry about things like correlation).
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> 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".
“Academic”