Imagine you are gambling and find out that you have an edge on
the game. For instance, say you are betting on the outcome of a coin flip which
is usually a 50% heads / 50% tails proposition, but in this case, you have
knowledge that the coin being flip will show heads 60% of the time, and tails
just 40%. If given these facts, one might want to put everything that have on
heads. The downside of such a strategy, is there is still a 40% chance you
might go bankrupt on the first flip.
Given the known advantage you have, if you take the opposite
extreme where you wager just a small portion of your bankroll to be safe, you’ll
avoid bankruptcy, but you’ll also fall short of the optimal profit you might
make over the long run.
This problem of optimizing profit was recognized going back
to beginning of probability theory in the 18th century when Daniel Bernoulli
suggested that when one has a choice of a series of bets or investments, one should
choose that with the highest geometric mean of outcomes.
Move forward to the 20th century, Bell Labs researcher,
J. L. Kelly, Jr., formalize this strategy in establishing the Kelly Criterion (also
known as the Kelly Bet or Kelly Strategy).
The strategy to optimize the long-term outcome, is with each
bet to a certain fraction of your total bankroll. This fraction (f) is given by
the formula:
f = p – q/b,
Where f is the fraction of the current bankroll to wager,
p is the probability of winning
q is probability of losing, and
b is proportion of the bet gained with a win (the odds being offered)
In our example with the dishonest coin flipping, p=0.6,
q=0.4, b=1
f = 0.6 – (0.4/1) = 0.2
So, our first bet would be wagering 20% of our bankroll. If
we won the first bet, our next wager would be adjusted higher to reflect the new,
higher bankroll. Or, if we lose the first bet, our next wager would be lowered
because our lower bankroll.
If you enter a casino, where with very few exceptions, you don't have an advantage, the fraction, f, is zero or negative - meaning you shouldn't wager anything.
Interestingly, there are applications beyond gambling where
this strategy is used. Warren Buffett and other well-known investors used this
strategy in allocating
their investments.
There is a good video by Adam Kucharski that also explains some applications of the Kelly Bet: (1584) How Science is Taking the Luck out of Gambling - with Adam Kucharski - YouTube
The website, Wizard of Odds, has a page on the Kelly Criterion and has the results of some simulations based on the criterion. https://wizardofodds.com/gambling/kelly-criterion/
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