What is 'The Kelly Criterion'

The Kelly criterion is 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.

The term is often also called the Kelly strategy, Kelly formula or Kelly bet.

Formula for calculating the Kelly criterion.

BREAKING DOWN 'The Kelly Criterion'

There are two key components to the formula for the Kelly criterion: 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.

More recently, the strategy has seen a renaissance, in response to claims legendary investor Warren Buffet and Bill Gross use a variant of the Kelly criterion.

The formula is not without its share of skepticism. Although the Kelly strategy's promise of outperforming any other strategy, in the long run, looks compelling, some economists have argued strenuously against it — primarily because an individual's specific investing constraints may override the desire for optimal growth rate. In reality, an investor's constraints whether self-imposed or not, are a significant factor in decision making capability. The conventional alternative includes expected utility theory, which asserts bets should be sized to maximize the expected utility of outcomes.

RELATED TERMS
  1. Formula Investing

    Formula investing is a method of investing that rigidly follows ...
  2. Flat Benefit Formula

    Flat benefit formula is one way of calculating an employee's ...
  3. Constant Ratio Plan

    A constant ratio plan is a strategic asset allocation strategy, ...
  4. Bond Equivalent Yield - BEY

    The bond equivalent yield is a calculation for restating semi-annual, ...
  5. Mean Return

    Mean return, in securities analysis, is the expected value, or ...
  6. Sterling Ratio

    Sterling ratio is a risk-adjusted return measure that uses compounded ...
Related Articles
  1. Investing

    Southwest Airlines Board Sticking With Kelly For Good Reason (LUV)

    Despite calls from its unions to oust CEO Gary Kelly, the board is sticking with their leader who has been able to deliver three years of record profits.
  2. Tech

    'Bitcoin Cash is a Must-own': Brian Kelly

    Brian Kelly reinforces Roger Ver's stance on Bitcoin Cash emerging as a popular cryptocurrency
  3. Investing

    Understanding the Black-Scholes Model

    The Black-Scholes model is a mathematical model of a financial market. From it, the Black-Scholes formula was derived. The introduction of the formula in 1973 by three economists led to rapid ...
  4. Investing

    All About REX, the New Actively Managed Blockchain ETF

    The ETF holds shares of 32 blockchain-related companies.
  5. Investing

    3 Expensive U.S. Large-Cap Mutual Funds (ACAAX, BOPBX)

    Discover three large-cap mutual funds that merit a position in your portfolio despite having sales charges and high expense ratios.
  6. Investing

    Financial Forecasting: The Bayesian Method

    This method can help refine probability estimates using an intuitive process.
  7. Investing

    Visa Inc. Announces Q4 and Fiscal Year 2016 Results (V)

    Charlie Scharf hands over Visa's top office to Alfred F. Kelly Jr. after posting a 28% earnings rise, beating analysts estimates for Q4 2016.
  8. Tech

    CAPM vs. Arbitrage Pricing Theory: How They Differ

    Both project the expected rate of return given the level of risk assumed, but they consider different variables.
RELATED FAQS
  1. What is the formula for calculating net present value (NPV)?

    Net present value (NPV) is a method of determining the current value of all future cash flows generated by a project after ... Read Answer >>
  2. What is the formula for calculating net present value (NPV) in Excel?

    Net present value is used to estimate the profitability of projects or investments. Here's how to calculate NPV using Microsoft ... Read Answer >>
  3. How do I use the holding period return yield to evaluate my bond portfolio?

    Find out how to use the holding period return yield formula to evaluate the performance of bonds in your portfolio, and view ... Read Answer >>
  4. What is the formula for calculating return on investment (ROI) in Excel?

    Find out more about return on investment (ROI) and the formula used for calculating return on investment for a company in ... Read Answer >>
Trading Center