I am a reader of Tom Tonguz’s blog (Tom is a venture capitalist at Redpoint Ventures). Although I’ve mentioned the Kelly Criterion before, it’s worth reading Tom’s post from earlier this year (Feb. 2021) where important investment attributes are discussed.
“First, to calculate the expected value of an investment don’t use the average (also called the arithmetic mean); use the geometric mean. The difference is simple, but powerful.
Imagine you have three investment options, each equally likely. They return 100%, 50% and 0%. The arithmetic mean/average/expected value is 50%: (100+50+0)/3. The geometric mean is 0%: cubic root of (100500). The Kelly criterion says don’t invest. Quite a different result.
Second, size your investment properly. Invest too much and bankruptcy looms. Bet too little, and your returns won’t amount to a pile of beans.
How do you calculate how much to bet? Kelly criterion says to bet more the greater your edge and the likelihood of success.
KC = W - (1-W)/RKC = kelly criterion (the percentage of your balance sheet to invest) W = probability of winning R = win/loss ratio…”
Tom Tonguz
Professional venture capitalists use it…
Until next year,
You Man,
Max Cantor