The Kelly Criterion: Make Bets In Areas Where You Have An Advantage
“If you play games where other people have the aptitudes and you don’t, you’re going to lose. And that’s as close to certain as any prediction that you can make. You have to figure out where you’ve got an edge.”
Naval Ravikant has a great quote that says what you work on and who you work with is far more important than how hard you work. The extension of this is that you want to work in areas where you have an obvious advantage.
The first time I saw Charlie Munger speak in Los Angeles (top 5 highlights of my life), he repeatedly talked about this. Here’s what he said (paraphrased):
I think about things where I have an advantage over other people.
I don’t play in a game where the other people are wise, and I’m stupid. I look for a place where I’m wise, and they’re stupid.
God bless our stupid competitors - they make us rich.
You have to know the edge of your own competency.
I’m very good at knowing when I can’t handle something.
The best reason to play in areas where you have an advantage is to avoid getting wiped out. You want to avoid losing everything and starting again from zero.
The Kelly Criterion is a simple mental hook to remind you not to risk everything in one go.
What’s the Kelly Criterion?
The Kelly Criterion is a relatively simple math equation to determine the percentage of your bankroll you should bet on any given circumstance, assuming you have an advantage.
The goal of the equation is this: don’t go broke. The equation tells you exactly how much to bet on each “hand” so that you can survive to keep playing.
Here’s Naval Ravikant talking about the importance of the equation:
The Kelly criterion is a popularized mathematical formulation of a simple concept. The simple concept is: Don’t risk everything. Stay out of jail. Don’t bet everything on one big gamble. Be careful how much you bet each time, so you don’t lose the whole kitty.
John Kelly created the equation to analyze long-distance telephone signals but quickly realized the formula could apply to investing and wealth creation, too.
Ultimately, the Kelly Strategy relies on situations where the gambler has an advantage. The formula needs those odds to compute your optimal bet, which is a steady percentage of your total capital.
As your wealth increases, the proportion remains the same, but your bet grows. If you lose on any number of hands, and your wealth decreases, so will your bet.
The upside of this is that only betting a portion of your wealth (almost) guarantees you will never go completely broke.
In Fortune’s Formula: The Untold Story Of The Scientific Betting System That Beat The Casinos And Wall Street, author William Poundstone explains:
Elwyn Berlekamp, who worked for Kelly at Bell Labs, remembers Kelly saying that gambling and investment differ only by a minus sign. Favorable bets are called ‘investments.’ Unfavorable bets constitute ‘gambling.’
The Kelly Criterion Equation.
For an even money bet, the formula is pretty straightforward. Simply multiply the percent chance to win by two, then subtract one, and you’ll have your wager size percentage.
K = 2(W) - 1
For example, say you find that “rare situation” Kelly spent his life defining, and happen across some friends gambling on a coin flip. You know the coin is rigged, and the chance of getting heads is 60% and tails only 40%.
To find how much you should wager on heads, multiply your winning chance (0.6) by 2, and you’ll get 1.2. Subtract one from that, and your answer is you should bet 20% of your available wealth. Whether you win or lose, the Kelly Criterion will have you continue to bet 20% of your wealth.
The formula can get a bit more complicated as it becomes more personalized when applied to your investments because it factors in your personal win / loss ratio. Investopedia breaks down how to use the Kelly Strategy within your portfolio, with tips on how to access all the information you’ll need.
Play In Areas Where You Have An Advantage.
If that was too much math for you, don’t worry about it.
Qualitatively, the concept exists to keep gamblers from betting it all —no matter the odds. At its core, it can help you avoid ruin, and is most useful when you’re privy to “insider knowledge” (when you have an advantage over others).
That insider knowledge could be a better awareness of your own investment odds or a unique combination of skills that few others have.
Kelly was actually thinking more literally when he designed the formula. In Fortune’s Formula, Poundstone writes,
In describing his system, Kelly resorted to louche examples (rigged horse races, a con game involving quiz shows…). The subtext is that people do not knowingly offer the favorable opportunities that the Kelly system exploits. The system’s user must keep quiet about what he or she is doing… the Kelly gambler must stop when his private information becomes public knowledge.
Today, most of us are not betting on rigged horse races. Instead, we’re turning to the market and working with favorable odds where we can find them. Or, we’re building a skill stack in areas we already have an advantage.
Just Don’t Lose It All.
The Kelly Criterion is a mental hook to keep you from risking ruin by betting it all in one go.
Naval Ravikant reminds us that the simplest way to “lose it all” is to end up in jail by doing something illegal OR by destroying our reputation by doing something immoral or unethical. These factors are more likely to reset your career to “0” than actually facing financial ruin. So, protect your reputation and your freedom first, always.
Don’t risk everything you have in one go. Survive so you can keep playing the game.
And keep going.
Special thanks to Emma Cranston for her help in creating this article.
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ARTICLE SOURCES:
Read Naval Ravikant's post on the Kelly Criterion here: https://nav.al/kelly-criterion
Poundstone, William. Fortune's Formula. Farrar, Straus and Giroux. Kindle Edition.