In Part I, I reviewed William Poundstone's book, Fortune's Formula, which discusses the Kelly Criterion. The great part of the book for me is the detailing of fight between the Efficient Market Hypothesis (and Nobel Prize winning) Robert Merton/Paul Samuelson crowd who call the Kelly Criterion a "fallacy" and the Thorp/Shannon Pro-Kelly camp who have astonishing investment returns that appear to simultaneously validate the Kelly approach and disprove the Efficient Market Hypothesis.
Most money managers today are using the Markowitz Criterion, as Pounstone calls it. Michael Mauboussin of Legg Mason writes a great expanded summary of the Kelly fight, and also explains why "modern" money managers don't typically utilize the Kelly Criterion. The short answer: Kelly is only good when applied over and over for a long period of time and you reinvest your proceeds to achieve compound returns, and Kelly losses and volatility (during unlucky streaks) are hard to deal with psychologically. Neither of these features is suited to most money managers who have a short-term focus because they risk losing assets otherwise, therefore most money managers accept the mediocre returns (over the long run) of the mean/variance (Markowitz) approach. Read Mauboussin after you read Poundstone's explanation. It is interesting that Poundstone and others speculate that Warren Buffett and Charlie Munger are closer adherents of the Kelly approach than the Markowitz approach.
There appears to be no dispute that over the long haul, the Kelly approach is mathematically proven to outperform all other strategies in terms of total return. Samuelson's critique of the Kelly approach boils down to the fact that Samuelson believes the Kelly approach is not consistent with the utility function of most investors. Many investor's utility functions will not tolerate the inevitable drawdowns and volatility of the Kelly approach. Utility functions, however are somewhat subjective. The pro-Kelly camp believes that maximizing the compound annual growth rate of assets is the most rational approach (utility function) in the long run. Others disagree. Another question is how long is the long run? Morten Christensen gives excellent details in a long but mostly readable and up-to-date paper titled On the History of the Growth Optimal Portfolio. This is an excellent read for those desiring a lot more technical details than Poundstone provides. Recent theoretical studies show that the Kelly Approach can require an investing lifetime or more before it can be said to beat other "safer" approaches with a 95% confidence level.
The answer of whether the Kelly approach is better, in my opinion, is that it depends a lot on your situation. As Poundstone points out, it is probably more suited to traders than individual investors. In Part III, I'll discuss some other tidbits from the book and whether the Kelly criterion is appropriate for CASTrader.
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