Calculate the Kelly Criterion to Determine Investment Allocation

The Kelly Criterion is a mathematical formula that was devised to help gamblers determine the most favorable sizes for a series of wagers. Originally developed by John Larry Kelley Jr., the calculation also offers a method for maximizing long-term investment returns through a formula that accounts for both win/loss ratio and a winning probability factor. The result is the percentage of the investor’s total capital that should be allocated to the investment.

Calculate the Kelly Criterion

The formula for the Kelly Criterion can be written as:

Kelly% = W – [(1-W) / R]

Where:

W = Winning probability factor (the probability that the result of the trade will be positive)
R = Win/Loss Ratio (the total positive trade sums divided by the total negative trading sums)

Benefits and Downside Associated with the Kelly Criterion

In recent years, the Kelly Criterion has become an integral part of mainstream investment practice. Even Warren Buffett, the famous value investor, is rumored to subscribe to the theory. The calculation is viewed as a good tool for sizing an investment in proportion to the investor’s “advantage”.

On the downside, the Kelly Criterion requires the investor to know how well a trade strategy under consideration works. If the investor cannot accurately measure the advantage, the output from the calculation will not be meaningful.

Additionally, for many investors the volatility associated with adhering to a strict Kelly Criterion is too great. For that reason, a “Half Kelly” approach, under which half the amount recommended by the Kelly Criterion is invested, has become quite common.
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The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.

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