What Is the Kelly Criterion?

The Kelly Criterion involves a simple mathematical formula that determines the most predominant way to optimize a series of bets. Devised by a man named J.L. Kelly, Jr. in 1956, the Kelly Criterion is a high risk mathematical formula which economists and other financiers use when wagering money or other items of value. In most scenarios in which this method is used, this strategy does perform better typically than other similar theories.

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How Does the Kelly Criterion Work?

The Kelly Criterion is a mathematical formula: f* = bp – q/b = p(b+1)-1/b where f* is the fraction to be wagered, be is the net odds received on the wager, p is the probability of winning, and q is the probability of losing. Simply put, pb should be larger than qa, which means that resulting output should exceed input. Those who can afford to lose large amounts may bet large amounts, expecting positive results, but this is not always the case.

When Should You Use the Kelly Criterion?

How Does the Kelly Criterion Work?

How Does the Kelly Criterion Work?

Investing, gambling and wagering are common practice, whether in the casino or in the stock market. Financial analysts advise people to divide their wealth, or portfolio, into many different markets so that there are high-risk investments, but also wealth that is theoretically safe from loss. While the Kelly Criterion generally demonstrates optimal growth rates or positive outcomes, many argue against it stating that the odds are high and that one should opt for a safer, more moderate method of betting or investing.

What is a Safe Criteria for Consideration of the Kelly Criterion?

Put simply, the Kelly Criterion is considered a volatile method of betting or gambling; outcomes can be very good, but can be equally bad. One of the predominant theories behind the Kelly Criterion is that wagering more than the Kelly amount will decrease the chances of positive results; the results historically will positively appear over longer amounts of time, but it is also possible to lose greatly in the beginning, making the long run a mute point. An analogy would be similar to the government placing social security funds into a high-risk scenario using this method.

Realities about the Kelly Criterion Method of Betting

Those who use this method of betting typically do not put all of their proverbial “eggs into one basket”; the majority will bet some using the Kelly Criterion and protect the rest with safer options. The equation used with the Kelly Criterion assumes the absence of costs or minimums. The one who places maximum funds or other items of value at risk using this formula must be able to suffer great loss, also referred to as the gambler’s ruin scenario.

Referring to the previous analogy about social security, it would be more comforting to know that the funds were invested safely. Considering the possibility of loss, millions could be without funds for basic living necessities because of unwise and uncertain investing. Wagering necessary funds with a high risk of loss is not a safe method, especially for the novice investor or gambler or with assets that cannot afford to be lost.


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