Key insights
- The post explores applying the Kelly Criterion to S&P 500 investing, suggesting that historical data supports leveraging investments approximately 2.4x. It acknowledges the risks and mentions advisors suggesting a "quarter Kelly" approach. While theoretical, increased retail leverage could amplify market swings, especially if volatility rises. This could lead to higher highs and lower lows in the short term.
I want to start by saying this is not intended for specific circumstances that are highly sensitive to variance (close to retirement for example) - but I’d like to hear if anyone has considered the implications of the Kelly Criterion on their own portfolio.
A very brief and incomplete summary to anyone not familiar:
Consider a game where you flip a coin at even odds however the coin is weighted 60% heads, 40% tails. With a bankroll of $100, the optimal amount you should bet on this game is given by the kelly criterion as 20% of your bankroll.
The kelly criterion can be used to calculate optimal wagers on positive expected value (EV) games.
Investing in the S&P 500 is positive EV - historical returns are ~+7%.
In Kelly’s paper, the criterion can be simplified in a continuous return form as: K = return / variance squared
So, for the S&P 500 historically if we use 7% as the rate of return and 17% as variance we get K = 2.42 suggesting leveraging ~2.4x is optimal.
In my own experience I have heard real advisor professionals suggest “quarter Kelly” or similar. Has anyone seriously applied this idea to how they think about their own portfolio? I’d love to know and hear your thoughts.
Edit: Kelly himself did not apply the criterion to continuous returns that was Ed Thorp later on. Apologies