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Understanding Fortunes Formula

Understanding Fortunes Formula

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Published by TraderCat Solaris

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Published by: TraderCat Solaris on Jun 26, 2010
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12/15/2011

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Column overall title:A Mathematician on Wall StreetColumn 22
Understanding Fortune’s Formula
by Edward O. ThorpCopyright 2007In January 1961 I spoke at the annual meeting of the AmericanMathematical Society on “Fortune’s Formula: The Game of Blackjack
.
” Thisannounced the discovery of favorable card counting systems for blackjack.My 1962 book
Beat the Dealer 
explained the detailed theory and practice. The “optimal” way to bet in favorable situations was an important feature. In
Beat the Dealer 
I called this, naturally enough, “The Kelly gambling system,”since I learned about it from the 1956 paper by John L. Kelly. I’ve continuedto use it successfully in gambling games and in investing. Since 1966 I’vecalled it “the Kelly criterion” in my articles. The rising tide of theory and of practical use by several leading money managers received further impetuousfrom William Poundstone’s readable book about the Kelly Criterion,
Fortune’sFormula
. (I approved the use of the title.) At a value investor’s conferenceheld in Los Angeles in May, 2007, my son reported that “everyone” said theywere using the Kelly Criterion. The Kelly Criterion is simple: bet or invest so as to maximize theexpected growth rate of capital, which is equivalent to maximizing theexpected value of the logarithm of wealth. But the details can bemathematically subtle. Since they’re not covered in Poundstone (2005) you6/25/20101
 
may wish to refer to my article “The Kelly Criterion in Blackjack, SportsBetting and the Stock Market” (Thorp 1997, 2000, 2006).Mohnish Pabrai, in his new book
The Dhandho Investor 
, gives examplesof the use of the Kelly Criterion for investment situations. Consider hisinvestment in Stewart Enterprises (pages 108-115). His analysis gave a listof scenarios and payoffs over the next 24 months which I summarize in Table1.
Table 1 Stewart Enterprises, Payoff Within 24 Months
Probability Return
1
0.80
 p
=
1
100%
 R
>
2
0.19
 p
=
2
0%
 R
>
3
0.01
 p
=
3
100%
 R
= −
 ______________________________ Sum=1.00 The expected growth rate
( )
 g f  
if we bet a fraction
 f  
of our net worthis(1)
( ) ( )
31
ln 1
i ii
 g f p R f  
=
= +
where
ln
means the logarithm to the base
.
e
When we replace the
i
 p
 by their values and the
i
 R
by their lower bounds this gives the conservativeestimate for
( )
 g f  
in equation (2):(2)
( ) ( ) ( )
0.80 ln 1 0.01ln 1
 g f f f  
= + +
6/25/20102
 
Setting
( )
0
 g f  
=
and solving gives the optimal Kelly fraction
* 0.975
 f  
=
 noted by Pabrai. Not having heard of the Kelly Criterion back in 2000, Pabraionly bet 10% of his fund on Stewart. Would he have bet more, or less, if hehad then known about Kelly’s Criterion? Would I have? Not necessarily.Here are some of the many reasons why.(1)Opportunity costs. A simplistic example illustrates the idea. SupposePabrais’ portfolio already had one investment which was statisticallyindependent of Stewart and with the same payoff probabilities. Then, bysymmetry, an optimal strategy is to invest in both equally. Call the optimalKelly fraction for each
*.
 f  
Then
2 * 1
 f  
<
since
2 * 1
 f  
=
has a positiveprobability of total loss, which Kelly always avoids. So
* 0.50
 f  
<
.
The samereasoning for
n
such investments gives
* 1/ .
 f n
<
Hence we need to knowthe other investments currently in the portfolio, any candidates for newinvestments, and their (joint) properties, in order to find the Kelly optimalfraction for each new investment, along with possible revisions for existinginvestments.Pabrai’s discussion (e.g. pp. 78-81) of Buffett’s concentrated bets givesconsiderable evidence that Buffet thinks like a Kelly investor, citing Buffettbets of 25% to 40% of his net worth on single situations. Since
* 1
 f  
<
isnecessary to avoid total loss, Buffett must be betting more than .25 to .40 of 
*
 f  
in these cases. The opportunity cost principle suggests it must be higher,perhaps much higher. This supports the assertion in Rachel and (fellowWilmott columnist) Bill Ziemba’s new book, “_______,” that Buffett thinks like6/25/20103

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