The magic formula in William Poundstone's book, Fortune's Formula is the Kelly Criterion, named after John Kelly who discovered it while working at Bell Labs. Want to maximize your capital growth in any repeated game of chance where you have an edge you can calculate? The surprisingly simple Kelly Formula tells you how much of your bankroll to risk on each bet, and in doing so, saves you from bankruptcy in the process if applied correctly. Poundstone basically summarizes the Kelly Formula on one page, and many gamblers and even some investors are already familiar with the Kelly Criterion - so why the 386 page book? The answer is two-fold:
First, Poundstone details the lives of John Kelly and his colleagues at Bell Labs: Ed Thorp and Claude Shannon. The story of Ed Thorp applying the Kelly Criterion (plus card counting) to the blackjack tables in early Las Vegas as well as the world of hedge funds (and cleaning house in both cases) is particularly fascinating, as is the the life of Claude Shannon, the father of information theory which is the very foundation of computers and the internet. Just as fascinating is the link between these three and various individuals/entities such as the mob, Micheal Milken, Ivan Boesky, Fischer Black, Robert Merton, Myron Scholes, Paul Samuelson, LTCM, Rudy Guiliani and even Warren Buffett.
Second, Poundstone details the outright hostility towards the Kelly Formula from the financial scholars, including Nobel prize winners Merton and Paul Samuelson. Paul Samuelson goes so far as to call the Kelly Criterion a "fallacy," although he technically does not disagree with the mathematical proof of the formula, rather he disagrees with it's application to the real world of finance, pointing out that while the Kelly Criterion will not make you go broke, it can result in serious drawdowns. Indeed, search around the internet, and you will find many gamblers and horse track bettors who seem to utilize the Kelly Formula but will tell you the same thing. Many of these people advocate using "1/2 Kelly" which trades less capital growth in return for much reduced drawdown during the inevitable unlucky streak. The explanation of the catfight between the Pro-Kelly Thorp/Shannon camp and the Anti-Kelly Merton/Samuelson camps is worth the price of the book alone. It's fascinating how Kelly Criterion fight seems to be a proxy for the Efficient Market Hypothesis (EMH) battle. Poundstone details how the amazing investing returns of Thorp and Shannon make a mockery of the Efficient Market Hypothesis. In fact, Poundstone details how the Kelly Criterion (which uses geometric mean) is superior to the darling of the EMH crowd: Harry Markowitz's Modern Portfolio Theory (which uses an arithmetic mean). More on this in Part II.
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