The Kelly Criterion: Optimizing Decision-Making in Risk Management

Abstract

The Kelly capital growth investment criterion, or Kelly criterion, defines the fraction of wealth to invest in a favorable investment opportunity such that the exponential growth rate is maximized. Maximizing the exponential growth rate is equivalent to maximizing logarithmic utility.[1] It all began in the mid-20th century when John L. Kelly Jr., a researcher at Bell Labs, developed the criterion as a solution to a problem related to the efficient transmission of information in telecommunications. Kelly introduced the concept of the Kelly Criterion within his paper “A New Interpretation of Information Rate,” which he published in his early years. However, he did not refer to the Kelly Criterion by its now- known name. The Kelly Criterion initially gained recognition in academic and mathematical circles, primarily for its applications in information theory. Then, professional gamblers and investors started using the Kelly Criterion to manage their bankrolls and make more informed betting decisions. The financial industry also embraced the Kelly Criterion as an alternative approach to portfolio management and investment strategies. The Kelly Criterion gained further attention in investment circles, particularly in hedge funds and wealth management.