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My earlier post laid out some important lessons on behavioral economics learned from Santa Fe Institute’s conference on Risk: the Human Factor. The specific lecture that first caught my eye when I saw the roster was Edward Thorp’s discussion on the Kelly Capital Growth Criterion for Risk Control. I had read the book Fortune’s Formula and was fascinated by one of the core concepts of the book: the Kelly Criterion for capital appreciation. Over time, I have incorporated Kelly into my position-sizing criteria, and was deeply interested in learning from the first man who deployed Kelly in investing. It's been mentioned that both Warren Buffett and Charlie Munger discussed Kelly with Thorp and used it in their own investment process. Thus, I felt it necessary to give this particular lecture more attention.

In its simplest form, the Kelly Criterion is stated as follows:

The optimal Kelly wager = (p*(b+1)—1) / b where p is the probability (% chance of an event happening) and b is the odds received upon winning ($b per every $1 wagered).

It was Ed Thorp who first applied the Kelly Criterion in blackjack and then in the stock market. The following is what I learned from his presentation at SFI.

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