In Part I, we reviewed Poundstone's book, Fortune's Formula, and in Part II attempted to answer whether Fortune's Formula (aka the Kelly Criterion) really is the best way to manage money. In this final part, I'll summarize what parts of Poundstone's book are applicable to the development of CASTrader.
To Kelly or not to Kelly. The CASTrader platform, being composed of many autonomous complex adaptive agents is the perfect environment to apply the Kelly Criterion. I personally have a utility function, but the thousands (millions?) or more trading agents that will eventually "live" in CASTrader won't have a utility function unless I give them one. In other words, they won't care about drawdowns or get psyched out by a losing streak unless I program them to - and right now I see no reason to. Their sole purpose in life is to maximize compound growth, which is exactly what the Kelly Criterion achieves. Therefore, the Kelly Criterion will be a key component of the CAS Trader platform for now. Ideally, many of the traders will trade frequently, allowing the Kelly Criterion to work it's magic. My assumption is that the diverse set of agents will be largely uncorrelated and thus mute the Kelly volatility and drawdowns so that the overall community portfolio returns do not violate my personal utility function. This will hopefully achieve the Holy Grail - Kelly optimal growth without the ulcers. I'm betting that there will be no need to limit individual traders to a fractional Kelly system.
Constant-proportion portfolio. Claude Shannon once advocated a constant-proportion rebalanced portfolio, which is a special case of the Kelly Criterion. Such a portfolio would keep say 50% in cash and 50% in a particular stock rather than putting everything in the stock, and you rebalance frequently as the stock changes in price. Shannon dismissed the idea due to commissions, but recently Mark Rubinstein and Eugene Fama, unaware of Shannon's unpublished work, have apparently published research that the optimal portfolio is always a constant-proportion portfolio. Unaware of either Shannon's and Fama's work, I independently investigated the constant-proportion rebalanced portfolio several years ago and it is close to how I manage my personal money now. In some future post, I'll detail my findings and experiences. I figure I get 1-4% additional return over a straight buy-and-hold strategy using this approach. On certain stocks, the returns from this approach can be 30% even if the stock returns 10% or less. The approach works by profiting from volatility - a kind of volatility arbitrage. Needless to say, this was an interesting part of the book for me. Variations on this approach will be incorporated into CASTrader.
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