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Leonard C. MacLean, Herbert Lamb Chair (Emeritus),School of Business, Dalhousie University, Halifax, NS Edward O. Thorp, E.O. Thorp and Associates, Newport Beach, CA Professor Emeritus, University of California, Irvine William T. Ziemba, Professor Emeritus, University of British Columbia, Vancouver, BC Visiting Professor, Mathematical Institute, Oxford University, UK ICMA Centre, University of Reading, UK University of Bergamo, Italy January 1, 2010

Abstract We summarize what we regard as the good and bad properties of the Kelly criterion and its variants. Additional properties are discussed as observations.

The main advantage of the Kelly criterion, which maximizes the expected value of the logarithm of wealth period by period, is that it maximizes the limiting exponential growth rate of wealth. The main disadvantage of the Kelly criterion is that its suggested wagers may be very large. Hence, the Kelly criterion can be very risky in the short term. In the one asset two valued payoﬀ case, the optimal Kelly wager is the edge (expected return) divided by the odds. Chopra and Ziemba (1993), reprinted in Section 2 of this volume, following earlier studies by Kallberg and Ziemba (1981, 1984) showed for any asset allocation problem that the mean is much more important than the variances and co-variances. Errors in means versus errors in variances were about 20:2:1 in importance as measured by the cash equivalent value of ﬁnal wealth. Table 1 and Figure 1 show this and illustrate that the relative importance depends on the degree of risk aversion. The

Special thanks go to Tom Cover and John Mulvey for helpful comments on an earlier draft of this paper.

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98 2. because a long sequence of bad scenario outcomes is possible.50 10. But.42 2. Since log has RA (w) = 1/w. T-Bill Nav Index % Cash Equivalent Loss 11 10 9 8 7 6 5 4 Means S&P500 3 2 1 0 0 0. The Kelly bets may be exceedingly large and risky for favorable bets.38 3.68 ↓ ↓ ↓ 20 10 2 Error Mean Error Var Error Covar 20 2 1 ∗ Risk tolerance=RT (w) = 100 1 R (w) 2 A (w) where RA (w) = − u (w) u Price (U. In MacLean.S.67 50 22. Zhao and Ziemba (2009) in this section of this volume. Ziemba lower is the Arrow-Pratt risk aversion.05 0. we present simulations of medium term Kelly.84 21. Thorp. any strategy can lose substantially even if there are many independent investment opportunities and the chance of losing at each investment 2 .05 75 56.Good and bad properties MacLean. which is close to zero. dollars) 15 14 13 12 11 10 9 8 7 6 5 4 3 2 1 0 11/68 10/73 11/77 PNP S&P 500 U. Thorp. Table 1: Average Ratio of Certainty Equivalent Loss for Errors in Means. fractional Kelly and proportional betting strategies.22 1. Chopra (1993) further shows that portfolio turnover is larger for errors in means than for variances and for co-variances but the degree of diﬀerence in the size of the errors is much less than the performance as shown in Figure 2.10 0.S.15 Variances Covariances 0. Source: Chopra and Ziemba (1993) Errors in Means Errors in Means Errors in Variances Risk Tolerance* vs Covariances vs Variances vs Covariances 25 5.20 Magnitude of error (k) 03 c-04 r-04 -04 p-04 c-04 r-05 -05 p-05 c-05 c-06 n n De Ma Ju Se De Ma Ju Se De De Date 10 Figure 1: Mean Percentage Cash Equivalent Loss Due to Errors in Inputs. the higher are the relative errors from incorrect means. Variances and Covariances. Kelly bettors attain large ﬁnal wealth most of the time. The results show that with favorable investment opportunities. RA = −u (w)/u (w).

See the wealth graphs reprinted in section 6 from Ziemba (2005). are never a sure way of winning for a ﬁnite sequence.25 .Magnitude of Error (k) Means Variances Covariances Source: Based on data from Chopra and Ziemba (1993). Long Term Capital is one of many real 3 . In Section 6 of this volume. and Covariances MacLean. The Research Foundation of AIMR™ decision point is small. the growth rate becomes zero plus the risk free rate when one bets exactly twice the Kelly wager. Graphs such as Figure 3 show that growth is traded oﬀ for security with the use of fractional Kelly strategies and negative power utility functions. Utility functions such as positive power that bet more than Kelly have more risk and lower growth. Good and bad properties Figure 1. One of the properties shown below that is illustrated in the graph is that for processes which are well approximated by continuous time. Thorp. Our analyses suggest that Buﬀett seems to act similar to a fully Kelly bettor (subject to the constraint of no borrowing) and Keynes like a 80% Kelly bettor with a negative power utility function −w−0. As you exceed the Kelly bets more and more. variances and covariances.8. Log maximizes the long run growth rate. see Ziemba (2003). risk increases and long term growth falls. The Kelly and fractional Kelly rules. Keynes and Buﬀett. we describe the use of the Kelly criterion in many applications and by many great investors. were long term investors whose wealth paths were quite rocky but with good long term outcomes. Source: Based on data from Chopra (1993) 12 ©2003. eventually becoming more and more negative. See Ziemba (2009) in this volume. Figure 2: Average turnover for diﬀerent percentage changes in means. Ziemba Average Turnover (% per month) 50 40 Means 30 Variances 20 10 Covariances 10 5 10 15 20 25 30 35 40 45 50 Change (%) Source: Based on data from Chopra (1993). so Kelly dominates all these strategies in geometric riskreturn or mean-variance space. Hence it never pays to bet more than the Kelly strategy because then risk increases (lower security) and growth decreases. Two of them. Average Turnover for Different Percentage Changes in Means. like all other rules. Variances.

next two columns. they both will provide the same optimal portfolio when α is invested in 2. We call betting | 0. Source: McLean and Ziemba (1999) Figure 3: Probability of doubling and quadrupling before halving and relative growth rates versus fraction of wealth wagered for Blackjack (2% advantage.2 0.91 0. This formula does not apply more generally. p=0. See Ziemba and Ziemba (2007) for 0. Consider and 0. why this led me to work with Len MacLean on a through study of fractional Kelly strategies and and So if you want a less aggressive path than Kelly pick an appropriate δ.” which is simply a blend of Kelly0.9 of a stationary lognormal process and a given δ for utility function δwδ and α = 1/(1 − δ) 1.0 Kelly 0. α Risky This handy formula relating the coeﬃcient of (1999)negative power utility function to the Source: MacLean and Ziemba the Kelly fraction is correct for lognormal investments and approximately correct for other distributed assets. Thorp.00 0.8 0.19 0. gamesexample. how bets can be very tiny) next month.36 0. see MacLean.96 0.83 More Growth | As δ becomes more negative. for coin tossing.75 0.3 _ Range 0.49).70 higher.75 0.6 Good and bad properties MacLean.999 additional examples.00 the Kelly portfolio and 1 −Toois invested in cash. where f ∗ = p − q 0 is the Kelly bet. p + q = 1.89 cash.50 Relative Growth Rate 0.998 | 0.98 Thus long term growth maximizing investors should bet _Kelly or less. Source: MacLean and Ziemba (1999) Rates Versus Probability of Doubling Before Halving for Blackjack Table 3: Growth Kelly Fraction P[Doubling before of Current Halving] Wealth world instances in which overbetting led to disaster.6 the negative power utility function δω|δ for δ < 0. P r(X very largeq. 4 .Liwill discussFor example. p=0.74 aggressive since his absolute Arrow-Pratt risk aversion index is also0.84 0.4 for Safer 0. | 0.7 _ _ 0. where the returns investing using unpopular numbers in lotto For with low probabilities of success where P r(X = 1) = p.49). three topics: good and bad properties −1 and quarter Kelly is δ = −3.99 1.1 0. For the case 0.64 0. half Kelly is δ = of the Kelly log strategy In the Ziemba and I (2005).56 between 0 and 1. the investor is less 0. and futures and commodity are − 1) = (this illustrates ∗ fδ = p 1−δ − q 1−δ p 1 1−δ 1 1 +q 1 1−δ = pα − q α pα + q α which is not αf ∗ .94 Less Growth less than Kelly “fractional Kelly.51 and q=0.5 Blackjack 0.5 0.51 and q=0.67 1. Ziemba Figure 2: Probability of doubling and quadrupling before halving and relative growth rates versus fraction of wealth wagered for Blackjack (2% advantage. This utility function is concave and Teams Riskier 0.78 when δ → 0 it converges to log utility.0 Overkill à 0.51 0. 0.

See Ethier (1987. Zhao and Ziemba (2004) reprinted in section 3. Good If you wish to have higher security by trading it oﬀ for lower growth. See also Stutzer (2009) for a related but diﬀerent model of such security. Sanegre. He does not have to consider prior nor subsequent investment opportunities. For independent investments and any power utility a myopic policy is optimal. 1988) Good Simulation studies show that the ElogX bettor’s fortune pulls ahead of other “essentially diﬀerent” strategies’ wealth for most reasonable-sized samples. Thorp. MacLean.Good and bad properties MacLean. then use a negative power utility function. See Breiman (1961). updated from MacLean. See Breiman (1961). In fact past outcomes can be taken into account by maximizing the conditional expected logarithm given the past (Algoet and Cover. Thorp. 5 . Good The ElogX bettor has an optimal myopic policy. 2004. Ziemba and Hausch (1986) and MacLean. MacLean and Ziemba(1999) and Ziemba and Ziemba (2007). Zhao and Ziemba (2009) in this volume. See also Cover and Thomas (2006. or fractional Kelly strategy. See MacLean. The Good Properties Good Maximizing ElogX asymptotically maximizes the rate of asset growth. maximizing ElogX also asymptotically maximizes median logX. See Hakansson and Miller (1975) Good The absolute amount bet is monotone increasing in wealth. See Bicksler and Thorp (1973). see Mossin (1968). For example g ∗ g but g ∗ − g = will not lead to rapid separation if is small enough The key again is risk. Ziemba We now list these and other important Kelly criterion properties. Essentially diﬀerent has a limited meaning. Hakansson (1971) proved that the myopic policy obtains for dependent investments with the log utility function. δwδ . chapter 16). Ziemba and Blazenko (1992). This is a crucially important result for practical use. 2010) Good The ElogX bettor never risks ruin. Algoet and Cover (1988). General formulas are in Aucamp (1993). who show how to compute the coeﬃcent to stay above a growth path at discrete points in time with given probability or to be above a given drawdown with a certain conﬁdence limit. Zhao and Ziemba (2009) add the feature that path violations are penalized with a convex cost function. Algoet and Cover (1988) Good The expected time to reach a preassigned goal A is asymptotically least as A increases without limit with a strategy maximizing ElogXN . Browne (1997a) Good Under fairly general conditions.

Kelly gambling yields wealth X ∗ such that E( X ∗ ) 1. 1]. by maximizing the relative growth rate 1−f + fY c . for the wealth X induced by any other portfolio (Bell and Cover. the less wealth one should invest. . E( X ∗ ) 1.. although the exponential growth rate of wealth is inﬁnite for all proportions f and it seems that all f ∈ [0. We see that Kelly gambling is the heart of the solution of this two-person zero sum game of who ends up with the most money. k = 1. The growth rate G∗ of wealth resulting from repeated such investments is G∗ = max E ln(1 − f + 0 f 1 f X). Let U be drawn according to a uniform distribution over the interval [0. 1988). c where f is the fraction of wealth invested. and 1 let U be independent of X ∗ . The maximizing f ∗ is the Kelly proportion (Cover and Bell.e. Thus fairly randomizing one’s initial wealth and then investing it according to the Kelly criterion. 1980). . 1 1 + 2c Y 2 0 f 1 max E ln This is bounded for all f in [0. Any cost c for the St Petersburg random variable X. 1980. Thorp. Ziemba X Good Competitive optimality . the maximizing f ∗ in the previous equation guarantees that the f ∗ portfolio will asymptotically exponentially outperform any other portfolio f ∈ [0. P r X = 2k = 2−k . Then the result improves to P r [X U X ∗ ] 2 for all portfolios X. where E ln Y = ∞. probability 1 2 is the best competitive performance one can expect. but the f ∗ investor will exponentially outperform any other essentially different investor. Good Super St Petersburg. 6 . 2.Good and bad properties MacLean.2]. The Kelly fraction f ∗ can be computed even for a super St k Petersburg random variable P r Y = 22 = 2−k . Thus an opponent cannot outperform X than 1 . and for all other induced wealths t . i. But the larger the cost c. one obtains a wealth U X ∗ that can only be beaten half the time. . This follows from the Kuhn Tucker conditions. P r [X tX ∗ ] 1.1]. 1] are equally good. Good If X ∗ is the wealth induced by the log optimal (Kelly) portfolio. for t ∗ by a factor t with probability greater x. . for all other strategies X. Both investors’ wealth have super exponential growth. then the expected X wealth ratio is no greater than one. So we see that X ∗ (actually U X ∗ ) is competitively optimal in a single investment period (Bell and Cover 1980. is acceptable. Since a competing investor can use the same strategy. This inequality can be improved when t = 1 by allowing fair randomization t U . Thus by 1 Markov’s inequality. 1988). Now.

which results from maximizing expected utility in case the utility function is log or a negative power. This is a consequence of weighting equally rather than by size of the wager. For 7 . (See also the 74% future bet on the January eﬀect in MacLean. any ﬁxed fraction strategy has the property that if the number of wins equals the number of losses then the bettor is behind. the result is ﬁxed fraction betting. like any other strategy. The sequence {fi∗ } denotes i=1 the Kelly betting fractions and the sequence {fi } denotes the corresponding betting fractions for the essentially diﬀerent strategy. making 700 wagers all of which have a 14% advantage.d. Wild Again won this race. Bad The unweighted average rate of return converges to half the arithmetic rate of return. Bad For coin tossing.1% of the time.i. Half Kelly does not help much as $1000 can become $145 and the growth is much lower with only $100. Ziemba The Bad Properties Bad The bets may be a large fraction of current wealth when the wager is favorable and the risk of loss is very small. the least of which has a 19% chance of winning can turn $1000 into $18.000. 1971). see Ziemba and Hausch (1996). Thus you may regularly win less than you expect. See Ethier and Tavar´ (1983) and Griﬃn e (1985). For n wins and n losses and initial wealth W0 we have W2n = W0 (1 − f 2 )n . Slew ﬁnished third but the second place horse Gate Dancer was disqualiﬁed and placed third. For one such example. • Despite its superior long-run growth properties.6% of the time $1000 turns into at least $100. • The Kelly portfolio does not necessarily lie on the eﬃcient frontier in a mean-variance model (Thorp. Ziemba and Blazenko (1992) reprinted in this volume). Thorp and Ziemba actually made this place and show bet and won with a low fractional Kelly wager. the optimal fractional wager. process and a myopic policy. Thorp. hence fractional Kelly includes all these policies. 159-160). see Ziemba and Hausch (1986.000 plus ﬁnal wealth 0. in the inaugural 1984 Breeders Cup Classic $3 million race. But with full Kelly 16. • A betting strategy is “essentially diﬀerent” from Kelly if Sn ≡ n Elog(1+fi∗ Xi )− i=1 n Elog(1 + fi Xi ) tends to inﬁnity as n increases. on the 3-5 shot Slew of Gold was 64%. the ﬁrst great victory by the masterful jockey Pat Day. There. can have a poor return outcome.Good and bad properties MacLean. using the Dr Z place and show system using the win odds as the probability of winning. For example. Some Observations • For an i. Kelly.

Thorp. However. 2006). it takes 157 years for A to beat B with 95% conﬁdence. But if σα = 20%. µβ = 10%. The Kelly and fractional Kelly strategies are very useful if applied carefully with good data input and proper ﬁnancial engineering risk control. in continuous time with a geometric Wiener process. The theory and practical application of the Kelly criterion is straightforward when the underlying probability distributions are fairly accurately known. suppose µα = 20%. Prospective users of the Kelly Criterion can check our list of good properties. But the bad properties may dampen the enthusiasm of naive prospective users of the Kelly criterion. in investment applications this is usually not the case. 8 . For long term compounders. The following simple proof. Thorp. bad properties and observations to test whether Kelly is well suited to their intended application. Bernoulli trials f = 1 maximizes EU (x) but f = 2p − 1 < 1 maximizes ElogXN .the size of the wagers should be reduced. • It can take a long time for any strategy. betting exactly double the Kelly criterion amount leads to a growth rate equal to the risk free rate. Given the extreme sensitivity of E log calculations to errors in mean estimates. Stutzer (1998) and Janacek (1998) and possibly others. Appendix In continuous time. under the further assumption of the Capital Asset Pricing Model. the good properties dominate the bad properties of the Kelly criterion. Then in ﬁve years A is ahead of B with 95% conﬁdence. is due to Harry Markowitz and appears in Ziemba (2003). with a geometric Wiener process. 1/2 < p < 1.1%. See Samuelson (1971) and Thorp (1971. It takes two million trials to have an 84% chance that game A dominates game B. see Thorp (2006). • Fallacy: If maximizing ElogXN almost certainly leads to a better outcome then the expected utility of its outcome exceeds that of any other rule provided N is suﬃciently large. these estimates must be accurate and to be on the safe side. sharply reduce risk as their drawdown increases. σα = σβ = 10%. This result is due to Thorp (1997). σβ = 10% with the same means. see Bicksler and Thorp (1973) and MacLean. including Kelly. in coin tossing suppose game A has an edge of 1.Good and bad properties MacLean. Zhao and Ziemba (2009) in this volume. For instance. Counterexample: u(x) = x. to dominate an essentially diﬀerent strategy. As another example. Realized future equity returns may be very diﬀerent from what one would expect using estimates based on historical returns. Ziemba more such calculations.0% and game B 1. Consequently practitioners who wish to protect capital above all.

9 . Vp . namely Y = 2X for X above into 1 2 gp = r0 + (EM − r0 )Y − σM Y 2 2 and simplifying yields 4 2 2 g0 − r0 = 2(EM − r0 )2 /σM − (EM − r0 )2 /σM = 0. For a more general proof and illustration. Collecting terms and setting the derivative of gp to zero yields 2 X = (EM − r0 )/σM which is the optimal Kelly bet with optimal growth rate 1 2 2 g ∗ = r0 + (EM − r0 )2 − [(EM r0 )/σM ]2 σM 2 1 2 2 = r0 + (EM − r0 )2 /σM − (EM − r0 )2 /σM 2 1 = r0 + [(E − M − r))/σM ]2 . respectively. see Thorp (2006). Thorp. In the CAPM Ep = ro + (EM − r0 )X 2 V p = σM X 2 In continuous time where X is the portfolio weight and r0 is the risk free rate. variance and expected log. The CAPM assumption is not needed. Ziemba 1 gp = Ep − Vp 2 Ep . 2 Substituting double Kelly. 2 Hence g0 = r0 when Y = 2S. gp are the portfolio expected return.Good and bad properties MacLean.

Hakansson. Breiman. L. Bell. G. Ziemba (1981). Springer. Charles University. S. J. The eﬀect of errors in mean. Journal of Financial and Quantitative Analysis 8 (2). Miller (1975). Improving optimization. H. Management Science 30. Management Science 39. Cover (1988). Thorp. S. (2004). Game-theoretic optimal portfolios. In G. (1993). L. Browne. variance and covariance estimates on optimal portfolio choice. Journal of Portfolio Management 19. Management Science 22. Opitz (Eds. 10 . Chopra. J. and T. (1998). P. Tavar´ (1983). The proportional bettor’s return on investment. V. Survival and growth with a ﬁxed liability: optimal portfolios in continuous time. Journal of Applied Probability 41. On optimal myopic portfolio policies with and without serial correlation. 273–287. Kallberg. (1987). Competitive optimality of logarithmic investment. Proceedings of the 4th Berkeley Symposium on Mathematical Statistics and Probability 1. and T. M. V. Management Science 34 (6). 6–11. Ethier. 563–573. K. Bell. 1230–1236. Ziemba (1993). and B. 1540–1547. 161–166. N. K. and W. Journal e of Applied Probability 20. M. H. 391–400.). 324–334.Sc. S. Griﬃn. Ethier. Reno. and W. (1961). T. Thorp (1973). Math of Operations Research 22. M. Whitley (1981). and Thomas (2006). Elements of Information Theory (2 ed. Optimal gambling system for favorable games. Proceedings 7th International Conference on Gambling and Risk Taking. Bamberg and . and E. 876–898. 415–428. Cover. University of Nevada. R. Compound-return mean-variance eﬃcient portfolios never risk ruin. D. Thesis. Journal of Business 44. (1993). P. Asymptotic optimality and asymptotic equipartition properties of log-optimum investment. Optimal strategies for repeated games. (1985). (1971).). Bicksler. Janacek. Hakansson. S. The Doctrine of Chances: Probabilistic Aspects of Gambling.Good and bad properties MacLean. 51–59. Oelgeschlager. and R. 468–493. Journal of Investing 2 (3). Optimal growth in gambling and investing. 63–8. M. Ethier. O. Department of Economics. The proportional bettor’s fortune. S. Ethier. Methods of Operations Research. Remarks on optimal portfolio selection. Ziemba References Algoet. N. T. H. Prague. Finkelstein. Cover (1980). T. Math of Operations Research 5. M. Chopra. 724–733. and T. Aucamp. and S. The Kelly system maximizes median fortune. (1997). Diﬀerent measures of win rates for optimal proportional betting. K. 1163–1172. The capital growth model: an empirical investigation. Annals of Probability 16 (2). Cover (1988). Advanced Applied Probability 13. M. R. (2010). On the extensive number of plays to achieve superior performance with the geometric mean strategy.

. Ziemba (2009). Y. Annals of Operations Research 85. this volume. T. Wiley. A. C. g (2004). T. New York..Good and bad properties MacLean. sports betting and the stock market. this volume.. T. Capital growth with security. Gunn and Hain. pp. Optimal multiperiod portfolio policies. 108–122. Growth versus security in dynamic investment analysis. Journal of Portfolio Management Fall. and W. The fallacy of maximizing the geometric mean in long sequences of investing or gambling. Journal of Business 41. Working Paper. and W. J. Y. T. Ziemba. R. Bamberg and K. Quantitative Finance 5 (4). North Holland. T. and W. CA. A. Y. W. (1971). M. and Li (2005). Sanegre. MacLean. Samuelson. Dr. pp. MacLean. (2005). The symmetric downside risk Sharpe ratio and the evaluation of great investors and speculators. Betting at the Racetrack. S. Mossin. Charlottesville. Z. Ziemba. T. E. and G. The Kelly criterion in blackjack. L. L. (2009). R. L. Ziemba. MacLean. E. W. Stutzer. Dalhousie University. J. Utility theory for growth versus security. In S. Ziemba (2009). On growth optimality versus security against underperformance. Ziemba. Thorp. (2003). Zenios and W.). 215–224. T. O. T. P. Journal of Economic Dynamics and Control reprinted in this volume. 343– 357. and W. Ziemba (2007). pp. (1971). In G. L. Kallberg. MacLean. W. VA. Handbooks in Finance. Ziemba. Ziemba (Eds. 193–227. and W. T. Hausch (1986). T. W. Proceedings of the Business and Economics Section of the American Statistical Association. Zhao. Management Science 38. B. Investments. T.. (2009). Time to wealth goals in capital accumulation and the optimal trade-oﬀ of growth versus security. (2006).. Springer Verlag. Ziemba. Ziemba (1984). L. 11 . 1562–85. W. Zhao. Portfolio choice and the Kelly criterion. The stochastic programming approach to asset liability and wealth management. Ziemba Volume 44. Spremann (Eds. T. MacLean. O. O. G. E. 74–87. W. Optimal capital growth with convex loss penalties. Thorp. (1968). Zhao. T. Ziemba. Ziemba (1999). and W. Risk and Capital. Proceedings National Academy of Science 68. 2493–2496. Thorp. 507–520. AIMR. Mis-speciﬁcations in portfolio selection problems. Growth versus security tradeoﬀs in dynamic investment analysis. MacLean. 19 pages. Handbook of asset and liability management. E. Thorp.).. Blazenko (1992). L. Working Paper. 215– 229. and D. Scenarios for Risk Management and Global Investment Strategies. February. Medium term simulations of Kelly and fractional Kelly strategies. San Luis Obispo. 385–428.

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