Procs. o/the Business and Economics Sect. o/the Amer. Stat. Assoc.
, 215- 224 (1971) 81
PORTFOLIO CHOICE AND THE KELLY CRITERION
Edward O. Thorp, University of California at Irvine:O::
I. Introduction. The Kelly (or capital growt!.»
criterion is to maximize the expected value
E log X of the logarithm of tr.e wealth random
variable X. Logaritlunic utility has been widely
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dis c ussed since Daniel Bernoulli introduced it
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about 1730 in connection with the Petersburg
galne [3, 28]. However, it was not until certain
mathclnatical results were proven in a limited
setting by Kelly in 1956 and then in much more
general setting by Breiman in 1960 and 1961
thai logarithmic utility was clearly distinguished
~. its properties from other utilities as a guide
to portfolio selection. (Sec also [2, 4, 15], and
the very significant paper of Hakansson [II). )
Suppose for each timp. period (n ;:.1, 2, ... )
there are k investment opportunities with re-
sults per unit invested denoted by the family of
random variables Xn ,l'Xn ,2"" ,Xn,k' Suppose
also that these random variables have only fi-
nitely many distinct values, that for distinct n
the farrdlies are independent of each other, and
that the joint probability distributions of distinct
farnilies (as subscripted) are identical. Then
Breiman's results imply that portfolio strategies
1\ which Inaximize E log Xn , where Xn is the
wealth at the end of the n-th time period, have
the fol1owing properties:
Property 1. (Maximizing E log Xn asymp-
totic:c.:tlly maxiInizcs the rate of asset growth. ) If,
for each tim~ p~riod, two portfolio managers
have the same falnily of investmt'nt opportunities
or investn1.ent universes, and one uses a strategy
1\':: maximiz.ing Elog Xn whereas the other uses
an 'lessentially different l1 (1. e., ElogXn(II.*)-
E log Xn(/\)"~) strategy 1\, then lim XJI\*)/Xn(I\)" =
almost surely (a. s.).
Property 2. The expected time to reach a
fixed preassigned goal x is, asymptotically as
x increases I least with a strategy maxhni zing
ElogX;,.
The qualification '1essentially different" con-
ceals subtleties which are not generally appreci-
at~d. For instance [11], which is close in method
to this article, and whose conclusions we heartily
endorse, contains nUITlCroUS rnathematically
incorrect statemp.nts and several incorrect con-
clusions, mostly from overlooking the require-
mp.nt 11essentially different. 11 We intend to
present a detailed analysis elsewhere and only
indie.,te the problem here: If Xj = Xj!Xj-l' then
even though E log Xj>O for all j it need not be the
ca.'>c that P(lim Xn =00) = 1. "I n fact, we can have
215
Reprinted from the 1971 Business and Economics Statistics Section Proceedings
of the American Statistical Association
(just .as in the case of Bernoulli trials and
E log Xj = 0; sec (26)) P(lim sup Xn = m) = I and
P(lim inf Xn = 0) = I (contrary to [11, p. 522, eq.
(18)) and following assertions) . Similarly, when
Elogxj<O for all j we can have these alterna-
tives instead of P(lim Xn = 0) = 1 (contrary to [11,
p. 522, eg. (17)] and the following statemo.,tts;
footnote 1 is' also incorrect. )
Note (6) that with the preceding assumptions,
there is a fixed fraction strategy /\ which 111:lxi-
mizes E log Xn . A fixed fraction strategy is one
in which the fraction of wealth f
n,)
. allocated to
investmp.nt Xn,j is ~ndependent of n.
We emphasize that Breiman's results can be
extended to cover many if not nlost of the more
cornplicated situations which arise in real world
portfolios. Specifically, the number and distri-
butiqn of inve stmnnts can vary with the tinlt~
period, the randon1. variables need not be finit.e
or even discrete. and a certain amount of depen-
dence can be introduced between the investm(~:1t
universes for different time periods. \Ve have
used such extensions in certain applications (e.g.,
[25; 26, p. 287]).
We consider almost surely having more
wealth than if an l1essentially diffcrent l1 strategy
were followed, as the desirable objective for
most institutional portfolio managers. (It also
see:ms appropriate ·for w.aalthy families who
wish mainly to accumulate and whose consUlnp-
tion expenses are only a sInall fraction of their
total wealth.) Property 1 says that maximizing
E log Xn is a recipe for approaching this goal
asymptotically as n increases. This is Gar
principal justification for selecting E log X as
the guide to portfolio selection.
In any real application n is finite, the limit
is not reached, and we have P(Xn(R' )/Xn(A»I+ M)
=l .. qn,II.,M) where & ...... 0 as 0 ...... M>O is
(1).
given, N'I- is the strategy which maximizes
ElogXn · and A is an "essentially different" strat-
egy. Thus in any application it is important to
have an idea of how rapidly· e -to O. Work needs to
be done on this in order to reduce E log X to a
guide that is useful (not merely valuable) for
portfolio manage.rs. Some illustrative examples
for n=6 appear in[ll].
Property 2 shows us that nUl.xiITIizing E log X
also is appropriate [or individua~s who have a set
goal (c. g., to becorn0. a millionaire).
Appreciation of the compelling properties of
the Kelly criterion may have been impeded by
 82
certain l1.1.iSlll'ldcrstandings about it that persist.
in the literature of mathematical economics.
The first misunderstanding involve~ failure
to distinguish among kinds of utility theories .
\Ve COlnpare and contrast three types of utility
theories: (1) descriptive, where data on observed
behavior is fitted mathem.atically. Many differ-
ent utility functions might be needed', corres-
ponding to widely varying circumstances,
cultures, or behavior types l ; (2) predictive,
which "explains" observed data: fits for ob-
sCl"vf'd data arc deduced from hypotheses, with
the hope future data will also be found to fit.
Many different utility functions may be needed.
corresponding to the many sets of hypotheses
that lllay be put forward; (3) prescriptive (also
called normativeL which is a guide to behavior,
i. e., a recipe f;r optimally achieving a stated
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goal. It is not necessarily either descriptive or
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predictive nor is it intended to be so,
\Ve use logaritrunic utility in this last way,
and nHlch of the n1isunderstanding of it comes
frol11. those who think it is being proposed as a
descriptive or a predictive theory. The E log X
theory is a prescription for allocating resourCl~5
so as to (asymptotically) maximize the rate of
growth of as scts.
Another .iobjcetion" voiced by SOrnf! ecollO-
n1:'sts to E log X and, in fact to all unbounded
utility functions, is that it doesn't resolve the
(g(.'ncralized\ P(~ter5burg paradox. The rebuttal
is blunt and pragmatic: The generalized Peters-
burg paradox dues not arise'in the rea.l world
btcause anyone real world random variable is
bourdcd (as is any finite collection). Thus in a.ny
real application the paradox does not arise ..
To insist that a utility function resolve the
paradox is an artificial requirement, certainly
pern1is sible, but obstructive and tangential to
the goal of building a theory which is also a
practical guide.
2. Samllelson's objections to logarithmic utility.
Samllelson [21, pp. 245-6; 22, pp. 4-5] says that
repeatedly authorities [S, 6,14, IS, 30] ..... have
proposed a drastic simplification of the decision
problen1 whenever T [the number of investmcnt
periodsj2 is large.
Rule: Act in each. period to maximize the
geol11etric Jl1l.'an or the expected value of log x t '
The plausibility of such a procedure Cornp.s
fr0111 the recognition of the following valid asyn1p-
toLic result.
Theorem: Acting to ma.ximize the geometric
lnl~il.n at ~very step will if the period is "suffi-
ci(!mly long, II "aln"lOst certainly"3 result in
hj gilt' r tern"linal wealth and terminal utility than
(rOlli <Lny other decision rule, ": ..
IIFrol11. thi s indisputable fact. it is apparently
tl"ll~pljng to believe in the truth. of the following
f"d~>\· corollary~
False corollary: If maximiz~ng -the geo-
216
E. 0. Thorp
metric mean alnlost certainly leads to a bl."ttl "
outcomc, then the expc.cted value utility of it::;
outcomes exceeds that of any other rule, pro·
vided T is sufficiently large. It
Samuelson then gives count.cr(~xafnple5 t ( )
the corollary, Wt.~ heartily ag~'ec that the COl"l.!-
lary is false. In fact we had already sho'wn tin ··
for one of the utilities Salnllelson uses, for \Vl'
not.ed [26] that in the case o( Bernoulli u·i"l.
with probability 1/2<p< I of success, one;- shOUI'i
commi.t a fraction w == 1 of his capitn.l at. each
trial to maximize expected final gain E Xn (page
283; the utility is U(x) ::::x) whereas to InaxiInizl!
E log Xn he should commit w = Zp - I of his capi-
tal at each trial (page 285, Theorem -I).
The statC111ents v.·hieh we have seen in print
supporting this "false corollary" are by Latan~
[IS, p. lSI, fn. 13j as discussed in [ZI, p. 2-15,
fn. Ill. and Markowitz [16, pp. ix-x]. Latanc
may not have fully supported this coroJlary (or
he. adds the qualifier " . . . (in so far as certain
approximations are permissible) ... fl.
That thcrt.' were or are adherents of the
"false corollary" seenlS p\lzzling in viev.' of tIl<:
following forrrlll.lation. Consider a T stage ~r..
vcstn1.cnt process. At ~ach stage we allocate our
resources among the available invcsln1.('nts. For
each sequence A of all,?cations which Wi! choos,- _
there is a corresponding terminal probability
distribution F* of assets at the con1pletion of
stage T. For each utility function U(·} ~on· J
sider those allocations A:;:(U) which maxinlize
the expected value of terminal utility
J U(x) dF:(X). Assum~ sufficient hypotheses 010
U and the set of F: so that the integral is d e -
fined and that furthermore the maximizing al1o-
cation A';:(U) exists. Then Samnelson says that
A"'(log) is not in general A"(U) for other U.
This seems intuitively evident.
Even more seems strongly plausible: that if
z
U i ' and U are inequivalent utilities then
J UI(x) d F~(X) and J U2 (x) dF:(X) will in general
be m~ximized for different F:. (Two utilities
UI ai,d .U? are equivalent if and only if there are
constants a and b such that UZ(x) = aUI(x) + b,
a> 0; otherwise VI and Uz are inequivalent.) In
this connection we have proved:
Theorem: Let U and V be utilities defined
and differentiable on (0, m), with U'(x) and V'( .' I
positive and. strictly decreasing as x increa.!W5,
Then if U and V are inequivalent, there is a
one period lnv·estment setting such that U and V
have distinct optimal strategies. 4
All this is in the nature of an aside for
Samuelson's correct criticism of the "false
 Portfolio Choice and the Kelly Criterion
corollaryH docs not apply to our use of logarith-
mic utility. Our point of view is: if your goal i"s
property 1 or property 2 , then a recipe for
achieving either goal is to n"laximize E log X .
These properties distinguish log from the pro-
lixity of utility functions in the literature .
Furthermore, we consider these goals appro-
priate for n1.any (but not all) investors . Investors
with other uti1it.ie~ ;;-with goals incompatible
with logarithn1ic utility, will of course, find it
inappropriate .
Property I implies that if It' maximizes
E log Xn{/\) and A' is "essentially different, "
then Xn(Ir"') tends almost certainly to be better
than Xn(A') as n""'. Samuelson [21. p. 246).
apparently referring to this, says a!t~r refuting
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the !lIaIse corollary": "Moreover, as 1 sho'wed
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elsewhere [20. p. 4). the ordering principle of
selecting between two actions in terms of which
has the greater probability of producing a higher
result does not even possess the property of be-
ing transitive . . . . we could have wt,:*t; better than
\Y)~;:', and Wi,l~:t better than w*, and also have. w::t
better than wi,'*:';. II
For SOlne entertaining e xamples, ·see the
discussion of no.n-transit1.vc dice in [91 . (Consider
the dice with equiprobable faces numbered as
follows: X ~ -( 3.3.3.3,3.3); y ~ (4.4,4.4.1.1); Z ~
(5.5.2,2.2..2) . Then P(Z>Y) ~ 5/9. P(y>X) ~ 2/3,
P(X>Z) ~ 2/3.) What Samuelson does. not tell us is
that the property of producing a high;;-result
ahnost certainly, as in property 1, is transitive.
If 'wc have w ;;n:,::=>w~q almost certainly, and
w~;t~' >w::': alnlost ccrtainly, then we must have
w*~"'.: >w);t almost certainly.
One might· object [20. p . 6J that in a real in-
vestrnent sequence the limit as n -+(0 is not
reached . Instead the process stops at some finite
N. Thus we do not have XJI(o') > Xn(A') almost
certainly . Instead we have P(Xn(N'»Xn(A')) ~ 1- £N
where ~"'O as N-t co , and "transitivity can be
shown to fail.
This is correct. But an approximate form of
transitivity does hold: Let X, Y.Z be random var-
iables with P(X>Y)~I-€I ' P(Y>Z)=l-'2. Then
P(X>Z);, 1- (£1 + '"2'. To prove this, let A be the
event X>Y, B be the event Y>Z. and· C be the
event X>Z. Then P(A)+P(B) ~ P(AUB)+p(AnB)
~ l+p(AnB) . But A n BCC so PIC) ;o;p(AnB)
;0; P(A)+P(B) - I. i. e .• P(X>Z);o; I - ('I + '2.).
Thus our approach is not aHectcd by the vart-
ous Samuelson objections to the uses of logarith-
n1ic utility.
Mark~witz [16. pp. ix-x] says .... : inI955-56.
I concluded ... that the investor' who is currently
r e invC'sting everything for lithe long run" .s hould
maxilnize the expected yalue of the logarithm of
217
83
wealth. 11 (This assertion s e ems to be regal"Clle s s
of the investor's utility and so indicates b<:li e f in
the Bfalse coronary ." ") Mossin [181 and Sannlclson
[20] "II . . . have each shown that this concluf>ion i::;
not true for a wide range of [utility] functions ...
The fascinating ~1ossin-Samuelson result , CO!Y\-
bined with the straightforward arguments sup-
porting the earlie r conclusions, sE'.emcd pat'ad ux -
ical at first. 1 have since returned to the view of-
Chapter 6 (concluding that : for large T. the
Mossin-Samuelson Inan acts absurdly ... . I '
Markowitz says here, in effect, ,that alternate
utility functions (to log) are absurd , This position
is unsubstantiated and unreasonable.
He continues " ... like a player who would pay
an unlimited amount for the St . Petersburg
game ... ... If you agre~ with us that the St. Peters-
burg galYle is not realizable and may be ignored
when fashioning utility theories for the real 'world,
then his continuation I I •• , the tern1inal utility'func-
tion must be bounded to avoid this absurdity; .. , ! '
does not follow .
Finally, .J\1arkowitz says " .. . and the argl.: ~
ment in Chapter 6 applies when utility of tern1i-
nal wealth is bounded." If he means by this that
the "false corollaryll holds if we restrict our-
selves to bounded utility functions, then he is
mistaken. Mossin [18] already showed that the
optimal strategies for logx and xY/y, yt 0, are
fixed fraction fo r these and only these utilitie s.
Thus any bounde d utility besides x'l/v. 1'<0. \'." i ll
have optimal strategies which are not fixed frac.-
tion. hence not optimal for logx .. ""Sa";nuelson[22]
gives counterexan1ples which include·. the bounded
utilities xY/y. Y < O. Since Mossin assumes U "
exists and our theorem only aSSUlnes that U'
exists, it provides additional counterexao1ples.
3. An outline of the theory of logarithmic _utility
as applied to portfolio selection . 'The sim?lest
case is Bernoulli trials with probability p of
success, O<p<l. The unique strategy which n)ax-
imizes E log Xn i s to bet at trial n the fixed frac-
tion f" ~ P - q of total current wealth Xn;1 if
p>l!2 and to bet nothing otherwise.
To o1aximize E log Xn is equivalent to nlaxi-
mizing Elog[X
n
IX
0
]Im ".G(f). which we call th e
(exponential) rate of growth (pel" time period). It
turns out that for p >-li2. G(f) has a unique posi-
tive maxinlun1 at P:< and that there is a critical
fraction fc ' O<f':'<fc<l. such that G(fc)oO .
G (f»0 if 0 < f < fc' G (f)<0 if fc < f ~ I (we a s sumo
IIno margin"; the case with l'nargin is sirr\ilar). If
f<fc ' Xn -tee a . s.; if f= fe' lim sup ~ = +(0 a.s .•
and liminfX ~ 0 a . s . ; if f>f • limX ~ 0 a.s .
11 . c n·
(llruinl!~.
Bernoulli trials exhibit many of the features
 84 E. 0. Thorp

of the following more general case. Suppose we· simplex ~. Note that the dOlnain is convex and
have at each trial n = 1, 2, ... the k investlnent
includes ~ll of 1.0 in some neighborhood of the
opportunities Xn ,l,Xn ,2' ... ,Xn,k and that the con-
origin. Note too that the domain of G is all of ~
ditions of property 1, section 1 are satisfied.
This means that the joint distributions of if (and only if) R/ -I for all j. i.e . • if there is
{X . ,X ., ... ,X . j"l are the same for all n J for
\. n.l 1 n,l Z n,lj no probability of total loss on any investment.
The domain of G includes the interior of \ if
each subset of indices l;;i l <i 2 <· · ·<i/k. FUrther-
R;; -I. Both domains are particularly simple
more f?cm.I' .. . •Xm •k } and {Xn • l •...• Xn •k } are J .
and most cases of interest are included.
*
independent when m n, and all random variables
If fl' .... ~ arc chosen so that
X .. have only a finite number of distinct values.
1,)
I+fr + .. ·+fr ;;0 for some in . . . ·.m.
Thus we have in successive time periods repeat- I l.m l K k.,,\ I k
ed independent trials of lithe sanle" investment
universe.
then P(fIXn •1 + ... + ~Xn.k;; 0) = € > 0 for all nand
Since Breiman has shown that there is for ruin occurs with probability I . .
this case an optim.al fixed fraction strategy Computational procedures for finding an op-
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(li.*' ....
~). we will have an optimal strategy timal fixed · fraction strategy (generally unicjue in
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It' =
our present setting) are based on the theory of
if we find a strategy which maximizes ElogXn in
concave (dually. convex) functions [29J and will
the cIa S 5 of fixed fraction strategie s. be presented elsewhere . (As Hakansson [11, p .
Let "= (fl ... · .~) be any fixed fraction strat- 552] has noted. " ... the computational aspects of
the capital growth model arc [presently) much
egy. We assume that 1+· .. +~~1 so there is no
less advanced" than for the Markowitz model. J
borrowing, or margin. The margin case is sim- The theory lnay be extended to n10re general
ilar (the approach resembles [23]). Using the randoITl variables and to dependence between dif-
concavity of the logarithm, it is easy to show ferent time periods . Most important, we may
(see below) that the exponential rate of growth include the case where tht! investment universe
changes with the time period, provided only that
E log [Xn(A)1X0 ]1In = GUi • .. ·.V is a concave func-
there be some mild regularity conditions on the
tion of (fl ... · .~). just as in the Bernoulli trials X ..• such as that they be uniformly a . s. bounded
1,)
case. The domain of G(f) in the Bernoulli trials and that they do not tend to 0 uniforml y as i" ~ .
case was the interval [0.1) with G(f) 1-'" as f"l. (See [IS). and the generalization of the Bernoulli
The domain in the present instance is analogous. trials case as applied to blackjack in [26).) The
First, it is a subset of the k dimensional simplex techniques rely heavily on those used to genera-
1.0 = {(fl·· .. ·F 1
~+ ... +pl; ;;o ..... ~ ;;o} . lize the law of large numbers.
Transactions costs, the use of margin, and
To establish the analogy further. let R
. J the effect of tax'es can be incorporated into the
= Xn,j -1 , j = 1, ... ,k, be the return per unit on the theory. Bellman's dynamic programming method
is used here.
i-th investment opportunity at an arbitrary time
The general procedure for developing the
period n. Let the range of R be fro I; ... ; r .. }
J 1: J. J.1 j theory into a practical tool imitates Markowitz
[16]. Markowitz requires as inputs estimates of
and let the probability of the outcome ['\ =rl ' ml
the expectations, standard deviations, and co-
variances of the Xi,j' We require joint proba-
and R =r and " , and R = r I be
2 2.m 2 -k k.mkJ
bility distributions. This would seem to be a
p
m l .m 2 ..... "\ . Then ElogXn IXn-I =G(fi' ···.V much more severe requirement, but in practice
does not seem to be so [16. pp . 193-4. 198-201).
= l: ~ log (l+f r + ... + f r \ Among the actual i;"puts which Markowitz
mi' .... "\ I 1."1 K k.,,\ / chose were (I) past history [16. ex .• 8-20). (2)
I;;ml ;;\; ... ;I;;,,\;!;\}, from which the concavity probability beliefs of analysts (pp . 26-33). and
(3) models, most"notably regression models, to
of G(f l . .. .. ~' ) can be shown. Note that G(fl ••• · .~)
predict future performance from past data (p. 33 •
is defined if and only if 1+ fl 'I. "1 +.. . +~rk.,,\ >0 .pp. 99-100). In each instance one can get enough
additional information to estimate E log (XnlXn _1).
for each set of indices ml ... ·.Il).. Thus the do-
There are, however, two great difficulties
main of G(f1... · .~) is the intersection of all which all theories of portfolio selection have, in-
cluding ours and that of Markowitz. First, there
these open half-spaces with the k-dimensional
seems to be no established method for generally

216
 Portfolio Choice and the Kelly Criterion 85

predicting sC"curity prices which gives an edge of FIGURE 1. GROWTH RATE G (RETURN
even a few pc 1" cent. The random walk is the best RATE' R) IN THE E-a PLANE ASSUMING
model for security prices today. (See [7, 10j.) THE VALIDITY OF THE POWER SERIES
The second difficulty is that for portfolios APPROXIMATION.
v... ith 11lany securities the volume of inputs called
for is prohibitive : for 100 securities, Markowitz
requires 100 expectations and 4950 cQvar.i ances;.
and our theory requires somewhat more infor- 1.00
mation . Although considerable attention has been
given to finding condensed inputs that can be used
.90 and A.eli-I
instead, this aspect of portfolio theory still
seems unsatisfactory .
In the fifth section we will show how both .80
the se difficulties were overcome in practice by
an institutional investor. That investor, guided
.7
by the Kelly criterion, then outperformed for
the year 1970 everyone of the approximately400
Mutual Funds listed by the S & P stock guide!
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.60
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But fir.t we relate our theory to that of

Markowitz .
.W
4. Relation to the Markowitz theory; solution to
problems therein . The most widely used guide
AO
to portfolio selection today is probably the Mar-
kowitz theory . The basic idea is that a portfolio
PI is supedor to a portfolio P z If the expecta-
tion ("gain'l) is at least as great, i.e., E(P1)
1;E(PZ) and the standard deviation ("risk") is no
greater, i.e., a{PI)~a(pZ)' with at least one in-
equality. This partially orders the set (} of port-
folios. A portfolio such that no portfolio is
superior (i.e., a maximal portfolio in the partial .50 .60 .70 '
R<49% R'6~%
ordering) is called efficient. The goal of the
portfolio manager is to de termine the sct of effi-
cient portfolios, from which he then makes a
choice ba sed on his needs.
This is intuitively very appealing: It is based
on standard quantities for the securities in the G=ElogP approximately satisfy G=log{l+E)
portfolio, namely expectation .. standard deviation,
_ aZ(p)/2{l+El. This family of curves is illus-
and covariance (needed to compute the variance
trated in Figure I and the {efficientj portfolio
of the portfolio from that of the component secur-
which maximizes logarithmic utility is (approxi-
ities). It also gives the portfolio manager ''choice.1I
mately) the one which lies on the greatest G
As Markowitz [16, Chapter 6) has pointed out,
curve. Because of the convexity of the curve of
the optimal Kelly portfolio is approximately one
efficient portfolios and the concavity of the G
of the Markowitz efficient portfolios under cer -
curves, the (E, a) value where this occurs is
tain circmTIstances. If E= E{P) and R= P-I is
unique .
the return per unit of the portfolio P, let log P
The · approximation to G breaks down badly
= log (ltR) = log ( (ltE)+ (R - E)). Expanding in
in some significant practical settings, including
Taylor's series about ItE gives log P= 10g(I+E)
that of the next section. But for portfolios with
+ (R-E)/{l +E) - (R_E)Z /2{l +E)Z +higher order terms. large numbers of "typical" securities, the a"pprax...
Taking expectations and neglecting higher order imation for G will generally -provide an efficient
pot.'tiolio which approximately maxilnizes asset
terms gives ElogP= 10g{l+E)- J(P)/2{l+E)Z.
growth. This solves the portfolio manager's
This leads to a simple pictorial relationship
problem of which efficient portfolio to choose.
with the Markowitz theory . Consider the E-a
Also, if he repeatedly chooses his portfolio in
plane, and plot (E(P), a(P)) for the efficient
successive time periods by this criterion he wi ll
portfolios. The locus of efficient portfolios is a
tend to nlaximize the rate of growth of his as:i (' l s,
convex non-decreasing curve which includes its
i.c.,. nlaximize "performance. IIWe see also that
endpoints (Figure I).
in this instance the problem is reduced to that. of
Then constant values of the growth. rate
finding the efficient portfolios plus the easy step

219
 86
of using Figure 1. Thus if the Markowitz theory
can be applied in practice in this setting, so can
our theory.
We have already remarked on the ambiguity
of the set of efficient portfolios. and how our
theory resolves them .. To illustrate further that
such ambiguity repre.sent~ a defect in the Marko-
witz theory, let X1 be uniformly distributed over
[1.3]. let Xz be uniformly distributed over [10.
100], let cor(~.Xz)= 1. and suppose these are
the only securities. Then ~ and Xz are both
efficient with 01 < 0z and El < ~ so Markowitz '
theory does not choose between them. Yet
"everyone ll would choose Xz
over ~ because the
worst outcome with Xz is far better than the best
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outcome from ~. (We presented this example in
[Z6). Hakansson [11] presents further examples
and an extended analysis. He formalizes the idea
by introducing the notion of stochastic dominance:
X stochastically dominates Y if P(X~Y) = 1 and
P(X>Y) > O . It is easy to prove the Lemma: An
E log X optimal portfolio is never stochastically
dominated. Thus our portfolio theory does not
have this defect. )
There are investment universes ()\" .. JXn~
such that a unique portfolio P maximizes ElogP
yet P is not efficient in the sense of Markowitz .
Hence choosing P in repeated independent trials
will outperform any strategy limited to choosing
efficient portfolios. In addition. the optimal
Kelly strategy gives positive growth rate, yet
sOlne of the Markowitz- efficient strategies ·give
negative growth rate and ruin after repeated
trials. We gave such an example in [Z6] and
another appears in [ll]. See also [ll. pp. 553-4]
for further discussion of defects in the Marko ..
witz model.
5 . The theory in action: re suIts for a real insti-
tutional portfolio. The elements of a practical
profitable theory of convertible hedging were pub-
lished in [Z7]. Thorp and I<assouI indicated an
annualized return on investments of the order of
Z5% per year . Since then the theory has been
greatly extended and refined with most of these
new results thus far unpublished.
The historical data which has been used to
develop the theory includes well over 100.000
observations of convertibles.
A convertible hedge transaction generally
involves two securities, one of which is conver -
tible into the other. Mathematical price rela-
tionships exist between pairs of such securities.
When one of the pair is comparatively underpriced.,
a profitable convertible hedge may be set \Ip by
buying the relatively underpriced security and
selling short an appropriate amount of the rela-
tively overpriced security.
220
E. 0. Thorp
The purpose of selling short the oVf:rpricl:: d
security is to reduce the risk in the pOSItion.
Typically, one sells short in a single hedge fr{)m
50% to 125% as much stock (in "share e quiva-
lents") as is held long. The exact proportions
depend on the analysis of the specific situation;
the quantity of stock sold short is s e lected to
minimize risk. The risk (i.e., change in asset
value with fluctuations in market prices) in a
suitable convertible hedge should .be much less
than in the usual stock markjat long positions.
The securities involved in conve rtible hedges
include comlnon stock, convertible bonds, con-
vertible. preferreds, and common stock purchase
warrants. Options such as puts, calls, and
straqdles may replace the convertible security.
For this purpose. the options may be either
written or purchased .
The theory of the convertible hedge is highly
enough developed so that the probability charac-
te ristic s of a. single hedge can be worked out
based on.an assumption for the underlying dis-
tr·i bution of the comlnon . (Sometimes even this
can almost be dispensed with! See [27. App. CJ . )
A popular and plausible assumption is that the
future price of the common is log nor mally dis-
tributed about itst current price, with a trend and
a variance proportional to the tin1e . Plausible
estimates of these paran1eters are readily ob-
tained. Furthermore . it turns out that the return
from the hedge is comparatively insensitive to
changes in the estimates for these parameters.
Thus with convertible hedging we fulfill two
important. conditions for the practical application
of our. (or any other) theory of portfolio choice:
(1) We have identified investment opportunities
which arc markedly superior to the usual ones .
Compare the return rate of Z0'70-25% per year
with the long term rate of 8'70 or so for listed
common stocks. Further I it can be shown that
the risks tend to be much less. (2) The proba -
bility inputs are available for computing
O(fl • ...• ~).
On November 3, 1969, a private institutional
investor decided to commit all its resources to
convertible hedging and ·to use the Kelly criterion
to allocate its assets. The performance record
appears in the Table.
The market period covered included one of
the sharp~st falling markets as well as one ofthe
sharpest rising markets (up 50% in 11 months)
since Wor.ld War II. The gain was +16.3% for the
year 1970. which outperformed all of the approx-
imately 400 Mutual Funds Listed in the S 8< P
stock guide. Unaudited figures show that gains
were achieved during every single month.
The unusually low risk in the hedged posi -
tions is also indicated by the results for the ZOO
completed hedges . There were 190 winners . 6
break- evens, and 4- losses. The losses as a per
~ent of the long side of the specific investment
 Portfolio Choice and the Kelly Criterion 87

TABLE - PERFORMANCE RECORD

Change Elapsed ·Growth Rate DJIA Starting Gain Over

To Date Time To Date Closing Chg. Even With DJIA
Date ('/0) (months) ('70)++ DJIA+ ('/0)++ DJIA+ (%)

11- 3-69 0.0 0 855 0. 0 855 0.0

12-31-69 + 4.0 2 +26.8 800 - 6.3 889 + 10.3
9- 1-70 + 14. 0 10 + 17 . 0 758 -11.3 974 + 25.3
12-31-70 +21.0 14 + 17.7 839 1.8 1034 + 22.8
6-30- 71" + 39.9 20 +22.3 891 + 4 .2 1196 + 35.7
Assets on 7- 1-71 were 5.2 million.
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* Preliminary-unaudited .
by NANYANG TECHNOLOGICAL UNIVERSITY on 08/13/16. For personal use only.

+ DJIA = Dow Jones Industrial Average.

++Compound growth rate, annualized.

ranged from I '70 to 15% .

A characteristic of the Kelly criterion is
t r::-: -1 exp [ -(Iogx-IJ)21202] ,hence
(x)= (xo,,2n)
that as risk decreases and expectation rises, t 2
mean E(St) = 1xp(lJ+0 /2) and standard deviation
the optimal (raction of assets to be invested in
a single situation may become "large." On sev- O(St) = E(St) (eO -I J12. The functions 1.1 "U(t) and
eral occasions', the institution, discussed abotJ'e'
0" oCt) depend on the stock and on the time t. If
invested up to 30% of its assets in single hedge".
t is the tin"le in years until St is realized, it is
Once it invested 150% of its assets in a single
arbitrage. This characteristic of Kelly port- plausible to assume U(t) = log S +mt and O(tr = a2 t,
folio strategy is not part of the behavior of most
o
where So is the present stock price and n1. and a
portfolio Inanagers.
To indicate the techniques and probhnns, we are constants depending on the stock. For a de-
consider a sitnple portfolio with just one conver- tailed discussion, see [I, 19].
tible hedge. We take as our example Kaufman
Then E(S)=S exp[(m+a2/l)t] and a mean in-
and Broad common stock and warrants. A price t 0
history is indicated in Figure 2. crease o'f 10%/yea~ is approximated by setting
Price data shows that W= .455S is a reason-
able fit for S;§38 and that \V = S _ 21.67 is a
m+}/l = . 1 . If we estimate} from past price
changes we can solve for m . In the case of
reasonable fit for S ~ 44. Between S = 38 and
Kaufman and Broad it is plausible to take 0;'.45
S=44 we have the line W=.84S-15.5. For sim-
plicity of calculation we replace this in our illus- whence }= ,}o, . 20. This yields m,. O. We then
trative analysis by W= .5S if S;:;44 and W=S- 22 find O(St) =.5250 •
if S ~44. The lines are also indicated in Figure 2.
It is by no means established that the log-
Past history at the time the hedge was insti-
norm~l model is the app·ropriate one for stock
tuted in late 1970 supported the fit for S;:; 38.
price series [7, 10]. However, once we clarify
The conversion feature of the warrant ensured
certain. general principles by working through
W~S- 21.67 until the warrant expires . Thus
our example on the basis of the lognormal model,
W= S- 21.67 for S~44 underestimates the price
it can be shown that the results are substantially
of th e warrant in this region. Extensive histor-
unchanged by choosing instead any distribution
ical studies of warrants [12 , 13 , 24, 27] show that
that roughly fit. observation!
the past history fit would probably be maintained
For a time of one year, a computation shows
until about two years befoloe expiration, i.e., un-
the return R(S) on the stocl< to be +10.5%, the r("!-
til about March, 1972. Thus it is plausible to
turn R(W) on the warrant to be +34.8%, O(S) = .52.
assun1e that for the next 1.3 years S may be
cr(W) = . 92 and the correlation coefficient
I
roughly approximated by W = .5S for S;:; 44 and
cor(S, W) = .99. The difference" in R(S) and R(W)
W = S - 22 for S 1; 44 .
shows that the·warrant is a nnlch. better buy than
Next we aSSUJne that St' the stock price at
the comnlono Thus a hedge long warrants and
time t >0 years after .t he hedge was initiated, is short common has.a substantial positive expec-
lognor mally distributed with density tation. The value cor(S, W)= .99 shows that a

221
 88
FIGURE l. PRICE HISTORY OF KAUFMAN AND BROAD COMMON, S, VERSUS THE WARI{ AN TS, W.
The points moved up and to the right until they
reached the neighborhood of (38, 17). At this
point a 3:2 hedge (15,000 warrants long,
11,200 common short) was instituted .
As the points continued to move up
and to the right during the next
few n'lonths , the position was
closed out in stages with the
final liquidation at about
(58, 36).
25
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2
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w r a ry periods ; 750,OOO ...n i !Tt.ulb ;
hedge corresponding to the best linear fit of W
to S has a standard deviation of approximately
(1- . 99)1/2= . 1 which suggests that o(P) for the
optimal hedged portfolio is probably going to be
close to .1. The high return and low risk (or
the bedge will remain, it can be shown, under
wide variations in the choice of m and a.
To calculate the optimal mix of warrants
long to common short we Inaximize G(fl'~)
= E log (I +)S+~W) . The detailed computational
procedures are too lengthy and involved to be
presented here . We plan to present them
elsewhere.
Our instit\ltional investor considered posi-
tions already held, some of which might have to
be closed out to releas e a s sets, and also other
current candidates for inve stment. The decision
was made to short COnllTIon and buy warrants ill
the ratio of three shares to four. The initial
Jnarket value of the long side was about 14% of
assets and for the short sid e about 20% of assets
The net profit, in t e rms of the initial nl~rket
value of the long side, was about 20 ~o in six
months . This resulted fron1 a 'move in the
222
E. 0. Thorp
40 w·s
.
35
E{Sll,; <8.63
WIS, ) i. 29.66
Tc)'111S of warrant : 1 \v a r r anl
+ $21 . 67 .... I sha r e com nio n
stock un t il 3-1-74 . Full p r 0 -
tc c tion aga i n s t diluti on . The
con'rany h as t hf! right tl) r t"!ou ce
th e e x er c i se pl'ice fOl" lC'nl po-
and 5, 940,000 co n unon out.
standing . COlllmon d iv ide nd s
Q . 05 ex 10-26-70 .
comlnon frail,} about 40 to a l nlost 60,
6. Cdntluding rema r ks , As remarke d a b o .... e . w e
do not propose logarithnlic utility a s dc ::-. ~~ riptiv e
oC actual in vcstJn e n t be havior, nor d o we b e li e ve
,anyone utilit y fun c tion c ould suffi ce . It w ou ld be,
o! interest, ho we ve r, to hav e eln pirkc:d c-..tid e nc:e
showing ar e as of b e havio r which ar e cha.rac ter-
ized adequately b y logarithm ic utility , Neitl: c rdo
we intend Ibgarithmic utility to be prcdictivl! ;
aga i n, it would b e of inter e st to know what it
does predict .
We only propose the t heory t.o be nonn ati ve
or prescript'i vc, and o n ly for those in. s tit u tio n s,
groups, or individ u als who s e ove rriding curr en t
obj e ctive is n1a ximizati on of th e rat e of as s e t
growth. Those with a diffe rcnt "pri n1 c eli r c ctiv e"
may find that another \ltility function i$ a he tt e l'
gUide.
We have found ElogX to be ':alu"bl ~ a ' a
qualitative guide and s u ggest that thi s could. b e
its 'most inlportant \1 se , Onc e fa n i ili a rity Y\ l~' h
its properties is gained, Inany invc~tI1"H~, n t. fl ,) "
cisions can 'be guided by it without c Olnpl e x
supporting ca lc:ulation s,
What sort of econom,ic. b e havi o r can be E:.x ~
 Portfolio Choice and the Kelly Criterion
pected from followers of E log X ? Insurance is'
"explained,11 Le., even though it is a ne gative
expectation investment {or the insured and we
aS5unH: both insurer and insured have the same
probability information, it is often optitnal for
hin") (as well as for the insurance company) to in-
sure [3]. It usually tUrns out that insurance
against large losses is indicated and insurance
against sIl1all losses is not. (Don It insure an old
car fo,' collision, take $200 deductible, not $25,
etc. )
We find that if all parties to a security trans-
action are followers of E log X they will often
find it mutually optimal to trade. This may be
true whether the transactions be two party (no
brokerage), or three party (brokerage), and
whether or not the parties have the same proba-
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even about the entire investment universe.
Maximizing logarithmic utility excludes port-
folios which have positive probability of total loss
of assets. Yet it can be argued that an impover-
ished follower of E log X might in some instances
risk "everyt.hing." This agrees with some ob-
served behavior, but is not what we might at first
e xpect in view of the prohibition against positive
probability of tGtal loss . But consider each indi-
vidual as a piece of capital equipment with an
assignable monetary value. Then if he risks and
loses all his cash assets, he hasn't really lost
everything [3J.
All of us behave as though death itself does
not hav e infinite negative utility. Since the risk
of death, although generally srnall, is ever pre-
sent, a negative infinite utility for death would
n1ake all expected utilities negative infinite and
utility theory meaningless. In"the case of loga-
rithlnic utility as applied to the extended case of
the (monetized) individual plus all his resources,
death should be assigned a fin"ite, though large
and negative, utility. The value of this "death
constant l l is an additional arbitrary assumption
for the enlarged theory of logarithmic utility.
In the case of investor s who behave accord-
ing to E log X (or other utilities unbounded helow),
it might be possible to discover their tacit , 'death
constants. ,.
Hakansson [l!, p. 551J observes that loga-
rithnlic utility exhibits decreasing absolute risk
aversion in agreement with deductions of Arrow
and other s on the qualities of "reasonable l l utility
functions . Hakansson says, IIWhat the relative
risk aversion index [given by -xU'(x)!U'(x)]would
look like [or a meaningful utility function is less
cleaf . .. In. view of Arrow' s conclusion that
' . . . broadly speaking, the relative risk aversion
must. hover around 1, being, if anything, some-
what less for low wealths and somewhat higher
fo1' high wealths ... I the optinial growth model
scerns to be on safe ground. 1; As he notes, for
U(x):;: logx, the relative risk aversion "is pre-
ci~cly 1. However", in both the exte~sion to
223
89
valuing the individual as capital equipment, and
the further extension to include the death constant,
we are led to U(x)=log(x+c) where c is positive.
But then the relative risk aversion index is
x/(x+c) which behaves strikingly like Arrow's
description. See also the discussion of U(x)
~ log(x+c) in [8, p . 103, p . 112J.
Morgenstern [17J has forcefully obs cr\'~d
that assets are random variables, not num bers ,
and that econolni~ theory generally does not in-
corporate" this. To replace assets by their ex-
pected utilit>' in valuing companies, portfolios,
property and the like, allows for comparisons
when asset values are given as random variables.
We think logarithmic utility will often be c.ppr,?-
priate for such valuation.
I wish to thank Jame5 Bicksler for several
stimulating and helpful convers~tions.
FOOTNOTES
'::Edward O. Thorp is prafes sor, Department of
lvlathematics, University of Cali fornia at Irvine.
This . research was supported in part by the Air
Force Office of Scientific Research under Grant
AF-AFOSR 1870A. An expanded Version of this
paper will be submitted for publication elsewhere.
lInformation on descriptive utility is sparse; how
rnany writer s on the subj~ct have even been able
to dcterlnine for us their own personal utility?
2parenthetical explanation added since we ha ve
used n.
3"Almost certainly" and "almost surely" are
synonymous.
4 The proof of this theorem, and some further re-
sults obtained with R. Whitley, will appeal' else-
where.
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[1) Ayres, Herbert F., "Risl~ Aversion in the
Warrant Markets, II S . M. Thesis, M. 1. T . ,
Industrial Management Review 5: 1 (1963),
45-53 . Reprinted in Cootner, pp. 479-505.
[2J Bellman, R. and I(alaba, R . , "On the Role of
Dynamic Programming in Statistical Comn1un-
ication Theory, 11 IRE Transactions of the Pn~"­
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[3] Bernoulli, Daniel, IIExposition of a New
Theory on Hit:~ :t-..{easurcment of Risk, 11 Ec~~~­
metrica, XXlI (January 1954), 23-36, trans.
~Sommer.
[4J Borch, Karl H., The Economics ofUncerla;n'J:,
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[5] Brein1an, Leo, "Investment Policies for Ex-
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 90
[6] Breiman, Leo, "Optimal Gambling Systems
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[7] Cootne.r, P. H., ed., The Random Character
of Stock Market Prices, The M.1. T. Press, 19M.
[8] Freimer, MarshaH and Gordon, Myron S . ,
IIlnvestment Behavior . With Utili~y a Concave
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eds., Risk and Uncertainty, New York: St.
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[9] Gardner, Martin, IIMathematicalGames: The
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[lOJ Gr"nger, Clive and Morgenstern, Oskar, Pre-
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nletric model for CCmlTIori stock purcha se
warrants,1I Thesis. Columbia University,
1965; New York: Analytic Publishers Com-
pany, 1965. A regression model statistical
fit of nornlal price curves for warrants ...
There are la 'r ge systen1atic errors in the
model due to faulty (strongly biased) regreS-
sion techniques. The average n1.ean square
error in the fit is large. Thus, it is not safe
to use the model in practice as a predictor of
warrant prices. However, the model and the
methodology are valuable as a first qualita-
tive description of warrant behavior and as a
guide to a more precise analysis.
[13J Kassouf, Sheen T., "An econometric model
{or option price with in1plications for inves-
tors' expectations and audacity, II Econo-
metrica, 37:4 (1969), 685-694. Based on the
thesis . The \'ariance of residuals is given
as .24"8, or a standard deviation of about .50
in y, the normalized warrant price, and a
standard error of about .34 ,. The mid-range
of y varies {ron1 0 to . 5 and is never greater,
thus the caveat about not using the model for
practical predictions!
[I4J Kelly, J. L., "A New Interpretation ofInfor-
ITlation Rate, 'I Bell System Technical Journal,
35 (1956), 917- 926.
[15] Latane, HenryA., F~Criteria{orChoiceAn1.ong
Risky Venture 5, II Journal of Political Economy,
67 (1959), 144-155.
[16] Markowitz, H., Portfolio Selection, New York:
224
E. 0. Thorp
John Wiley and Sons, Inc., 1959 . Se e also the
preface to the second printing of the Yale
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[17] Morgenstern, Oskar, On the Accuracy of
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128.
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[21] Samuelson, PaulA., "Lifetime Portfolio Se-
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The Review of Economics and Statistics
(August 1969), 239-246.
[22] Samuelson, Paul A . , "The 'Fallacy' of Maxi-
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ces of Investing or Gambling, II Unpublished
preliITlinar)' preprint, 1971.
[23J Schrock, Nicholas W., "The Theory ·of
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and Long Positions in the FutUl'CS Market,"
Journal of Political Economy, 79:2 (1971 l,
270-293.
[24J Shelton, John P . , "The Relation of the Price
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Stock, II Financial Analysts Journal, 23: 3 (1967),
143-151; and Financial Analysts Journal,
23:4 (1967), 88- 99.
[25J Thorp, Edward, "A Winning Bet in Nevada
B~ccarat,1I Journal of the American Statis-
tical Association, 61, Part 1(1966), 313-
328.
[26J Thorp, Edward, "Optimal Gambling Systems
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273-293.
[27] Thorp, E. and Kassouf, S., Beat the Market,
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[28] Todhunter, 1. , A History oHhe Mathematical
Theory of Probability, lsted., Cambridge,
1865, as reprinted by Chelsea, New York,
1965. (See pp. 213 ff. for details on Daniel
Bernoulli's use of logarithmic utility.)
[29] Wagner, Harvey M., Principles of Opera-
tions Research, With Application to Mana-
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Hall, 1969.
[30J Williams, J. B., "Speculation and the Carry-
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