How Does the Fortune's Formula-Kelly Capital Growth Model Perform?

Leonard C. MacLean, Edward O. Thorp, Yonggan Zhao and William T. Ziemba

Chapter 8 in Great Investment Ideas, 2016, pp 147-173 from World Scientific Publishing Co. Pte. Ltd.

Abstract: William Poundstone's book, Fortune's Formula, brought the Kelly capital growth criterion to the attention of investors. But how do full and fractional Kelly strategies preform in practice? We study three simple investment situations and simulate the behavior of these strategies over medium term horizons using a large number of scenarios. The results show:the great superiority of full Kelly and close to full Kelly strategies over longer horizons with very large gains a large fraction of the time;that the short term performance of Kelly and high fractional Kelly strategies is very risky;that there is a consistent tradeoff of growth versus security as a function of the bet size determined by the various strategies; andthat no matter how favorable the investment opportunities are or how long the finite horizon is, a sequence of bad scenarios can lead to very poor final wealth outcomes, with a loss of most of the investor's initial capitalHence, in practice, financial engineering is important to deal with the short term volatility and long run situations with a sequence of bad scenarios. But properly used, the strategy has much to commend it, especially in trading with many repeated investments.

Keywords: Investment Management; Portfolio Theory and Practice; Great Investors; Stock Market Anomalies; Evaluation Theory; Portfolio Performance; Stock Market Performance (search for similar items in EconPapers)
JEL-codes: G11 (search for similar items in EconPapers)
Date: 2016
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