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Kelly criterion
When your favorite financial guru tells you that you should
invest 50% in stocks, 30% in bonds, 10% in gold, and 10% in cash,
do you ever wonder if there is a *rational* way to determine what
those percentages should be? Yes there is, although your guru
almost surely did not use it. The method is to use the *Kelly
criterion*. I described this criterion briefly in my article [2],
and gave a reference to an article by Edward Thorp [4] with much
more detail.
YEARS 1972-1991
World Inter
EAFE S&P 500 Gold Bonds Bonds T-bills
Here the S&P 500 is an index of the stock values of 500 of the
largest U.S. companies, which is widely used to measure "the
market". The Morgan Stanley EAFE (Europe-Australia-Far East)
Index is a less well known index of about 1000 stocks used to
measure the international market. The domestic return on a
foreign investment depends not only on how well the company does,
but on how the foreign currency varies with respect to the
dollar. This additional source of variation may explain why the
standard deviation of the EAFE Index is higher than that of the
S&P 500. The random variable in each case is the ratio Value(year
+ 1) / Value(year).
Distribution
6
Mean(P/P0) = SUM x[i] mean[i]
i=1
2 6 6
Std (P/P0) = SUM SUM x[i] x[j] std[i] std[j] corr[i,j]
i=1 j=1
2 .5
mu = ln(mean / (1 + (std / mean) ) ),
2 .5
sigma = (ln(1 + (std / mean) ) ,
Optimization
EAFE .114
S&P 500 .100
Gold .046
World Bonds .098
US Intermediate Bonds .088
US T-bills .074
Note that even though the mean return on gold was the third
highest at 11.0%, the Kelly criterion growth rate places it dead
last because its standard deviation was such a large 38.9%. In
other words, gold investment is just too risky. However, because
gold is negatively correlated with the other investments, it can
be useful in a *mixed* portfolio to reduce variance.
2
std = mean sqrt((mean / exp(mu)) - 1)
Thorp [3] shows another special case that can be easily solved on
a hand calculator. Note that if we determine the optimal
coefficients x[i] and purchase the corresponding portfolio, even
one day later this will no longer be the optimal portfolio. This
is because the values of the component securities are changing
daily, so that a portfolio with 90% EAFE today may have 91% EAFE
tomorrow. To maintain the optimal mix, one then needs to
rebalance by selling some of the EAFE. Let us assume that we
rebalance the portfolio very frequently ("continuously"), and
ignore any transaction costs.
2
x = ln(mean / mean(T-bills)) / sigma ,
mumax = .5 x + ln(mean(T-bills)).
Investment x mumax
Note that in four cases we have x > 1. These results can only be
achieved if we can go on margin and borrow money at the T-bill
interest rate. We are unlikely to be able to borrow money at that
good a rate, and we are unlikely to be able to borrow anywhere
near the amounts required for the largest x coefficients in the
table. If we prohibit borrowing, we should set x = 1.0 in these
four cases, with the corresponding reduction in mumax.
General Case
Investment Fraction
EAFE .868
S&P 500 .000
Gold .132
World Bonds .000
US Intermediate Bonds .000
US T-bills .000
Thorp [3] also shows how to solve the general case of mixing all
six investments, with continuous rebalancing and unrestricted
lending and borrowing of securities. Of course this case can also
be solved using the downhill simplex method that I used above,
but Thorp shows that in this case the equations are linear, and
thus can be solved by simpler techniques such as Gauss-Jordan
elimination.
Footnotes
2
mu = [approx] ln(mean) - .5 (std / mean) .
References
Risk Probability
by H. Jackson Zinn
"How did you acquire the T.V.?" asked the defense attorney of the
Defendant.
"I walked around the corner into the alley and I found it," the
Defendant replied.
The Judge looked upon the parties before him quite sternly.
"And you believed it? You're goofier than he is!" opined the
Judge.
In the aforesaid case, the adversary was forced to face the fact
that TRANS TIME had ample low-cost legal representation, and the
fact that even if they should win, there was no ten million
dollar fund at the end of the rainbow. Further, much of TRANS
TIME's property at the time was of far less value to outsiders
(e.g., dewars), and would cost a lot of money just to transport
or store.
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