Kelly Criterion
The Kelly Criterion is widely considered to be one of the cornerstones of modern portfolio management theory. In its most basic form, it is a formula for optimal portfolio allocation, relying on the principles of risk diversification and capital preservation. The Criterion produces a framework for determining the appropriate level of risk necessary to maximize expected returns over time, given a certain degree of uncertainty. It suggests that investors should adjust their portfolio risk in proportion to the relative volatility of their investments, taking into account the risk premium of each specific asset or sector.
At its heart, the Kelly Criterion states that an investor’s optimal portfolio will be one which takes the maximum Sharpe ratio*. The Sharpe ratio is a measure of a portfolio’s risk-adjusted return, which is calculated by subtracting the risk-free interest rate from the portfolio’s return on investment and dividing that number by the portfolio’s volatility. By taking into account a portfolio’s risk profile and its potential return, the Sharpe ratio helps investors measure how much reward they are getting in return for the risk they are taking.
To better understand how the Kelly Criterion works, let’s look at an example. Suppose an investor is considering a portfolio that contains stocks and bonds. Using the Criterion, the investor would calculate the Sharpe ratio of the portfolio and then determine what amount of bonds and stocks he/she should allocate to the portfolio in order to maximize its expected return. Since bonds tend to be less volatile than stocks, the Criterion would suggest that the investor should shift a larger portion of their portfolio into bonds compared to stocks. By investing more of the portfolio in bonds, the investor would reduce their portfolio’s risk, while still keeping a potential return that is close to the maximum potential return possible.
The Kelly Criterion also takes into account the concept of mean reversion, which states that a portfolio’s returns will tend to “regress” back towards the average over time. This is particularly important when it comes to volatile investments. By making use of the concept of “regression,” the Kelly Criterion helps investors make informed decisions about the risks they are able to, and should, take on in order to maximize potential gains while minimizing potential losses.
The Kelly Criterion is widely popular among financial advisors and portfolio managers. It simplifies the decision-making process for which assets to invest in, helping investors to quickly determine which portfolio options will produce the highest return at an acceptable level of risk. By taking into account the volatility of an asset or portfolio, the Criterion emphasizes the importance of diversification in order to ensure that investors are mitigating the risk of one asset or sector underperforming the rest.
The Kelly Criterion is a powerful tool for investors, providing an efficient way to maximize potential returns. While the concept of mean reversion often makes it difficult to accurately predict returns, the Kelly Criterion helps investors create structured portfolios that are tailored to the needs of each individual investor. While most financial advisors recommend that investors only invest according to their risk tolerance, the Kelly Criterion is a valuable tool for helping investors maximize potential returns while managing risk.
