Kelly Criterion

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Definition of 'Kelly Criterion'

The Kelly criterion, also known as the Kelly formula, is a formula for optimal investment in a risky asset. It was developed by John L. Kelly, Jr., a mathematician at Bell Labs, in 1956.

The Kelly criterion is based on the idea that the optimal investment strategy is to bet a fraction of your bankroll equal to the ratio of the expected return to the square root of the risk. In other words, you should bet more when the expected return is high and the risk is low, and less when the expected return is low and the risk is high.

The Kelly criterion is a simple and elegant formula, but it can be difficult to apply in practice. This is because it requires you to know the expected return and the risk of your investment. In many cases, these quantities are not known with certainty.

Despite these challenges, the Kelly criterion has been shown to be a very effective investment strategy over the long term. In a study of 25 years of data, researchers found that the Kelly criterion outperformed a buy-and-hold strategy by an average of 1.5% per year.

The Kelly criterion is not without its critics. Some people argue that it is too aggressive and that it can lead to large losses in volatile markets. Others argue that it is too simplistic and that it does not take into account all of the factors that should be considered when making an investment decision.

Despite these criticisms, the Kelly criterion remains a popular investment strategy among professional gamblers and investors. It is a simple and effective way to maximize your returns over the long term.

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