DEFINITION of 'The Kelly Criterion'
A mathematical formula relating to the long-term growth of capital developed by John Larry Kelly Jr. The formula was developed by Kelly while working at the AT&T Bell Laboratories. The formula is currently used by gamblers and investors to determine what percentage of their bankroll/capital should be used in each bet/trade to maximize long-term growth.
BREAKING DOWN 'The Kelly Criterion'
There are two key components to the formula: the winning probability factor (W) and the win/loss ratio (R). The winning probability is the probability a trade will have a positive return. The win/loss ratio is equal to the total positive trade amounts divided by the total negative trading amounts. The result of the formula will tell investors what percentage of their total capital that they should apply to each investment.
After being published in 1956, the Kelly Criterion was picked up quickly by gamblers who were able to apply the formula to horse racing. It was not until later that the formula was applied to investing.