Risk-Opportunity Analysis

by Ralph Vince

Every day, billions of human beings are making dozens of decisions that do not appear based on the same, seemingly sound mathematical principles they would apply to a gambling or investing situation. Yet these decisions are not irrational, rather they are the product of an innate sense pertaining to risk and opportunity with respect to the exigency of ever-present time.For decades various mathematical notions have presented themselves which, though applicable to domains such as probability, game theory, operations research, and quantitative finance, have fallen essentially outside the purview of these various disciplines. Yet the concepts detailed in this text are all related, and taken together comprise their own niche-discipline, introduced here as Risk-Opportunity Analysis.

273 pages, Paperback

First published February 3, 2012

Reviews

[Liquidlasagna]

probability - game theory - operations research - quantitative finance

I'd tend to Keynes and Michael Emmett Brady for thoughts on risk and probability

and I'll side with Taleb - The Black Swan and Fooled by Randomness
and Mandelbrot - The Misbehavior of Markets

and Ellsberg's book on Risk, Ambiguity and Decision - Game Theory/Nuclear War Planning/Economist/RAND/The Pentagon Papers

Patrick Boyle interviewed an author who used this book to read along with a mediocre book on making better Financial Decisions, which was a glorified version of the Kelly Criterion

[The Missing Bilionaires: A Guide to Better Financial Decisions - Haghani]
[bleh!]

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The Kelly Criterion is a mathematical formula used to determine the optimal fraction of a bankroll to wager or invest on a repeating basis. By balancing risk and reward, it maximizes the long-term compound growth rate of wealth while mitigating the risk of total ruin.

John L. Kelly Jr. created the Kelly criterion formula in 1956 at AT&T's Bell Laboratories. It helps determine how much to invest in a given asset to maximize wealth growth over time.


The Kelly Criterion is a formula created by John L. Kelly Jr. in 1956 to help maximize wealth growth by determining optimal investment sizes.

Originally intended for gambling, the Kelly Criterion calculates how much to invest in a single trade based on winning probability and win/loss ratio.

While beneficial for identifying investment proportions, the Kelly Criterion is not a standalone strategy, as it lacks consideration for portfolio diversification.

Some economists argue against the Kelly Criterion due to personal investment constraints that can affect optimal growth rates.

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Understanding the Kelly Criterion Formula and Its Applications

Gamblers began using the Kelly criterion in 1956 to make bets on horse racing. Later, investors like Warren Buffett and Bill Gross reportedly used the Kelly criterion in their strategies.

The formula helps determine the ideal amount to invest in a trade. There are two key components to the formula for the Kelly criterion:

a. Winning probability factor (W): Probability a trade will have a positive return.

b. Win/loss ratio (R): Equal to the total positive trade amounts, divided by the total negative trading amounts.
The result tells investors what percentage of their total capital should apply to each investment. The term is often called the Kelly strategy, Kelly formula, or Kelly bet.

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Warning

The Kelly Criterion can be useful, but investors should also consider diversification. Many investors should be wary about investing only in a single asset even if the formula suggests a high probability of success.

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Key Insights into the Kelly Criterion

The Kelly Criterion is a strategic formula designed to maximize wealth by determining the optimal allocation of an investor's capital in each trade. Developed by John L. Kelly Jr., it uses the probability of a positive return and the win/loss ratio to suggest precise investment amounts.

While offering a method to grow capital, it is critical for investors to balance this strategy with diversification and consider personal investment constraints.

The Kelly Criterion provides insights, but investors should apply it with caution, especially when applied to single trades.

[random thoughts via Investopedia]

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