Since the book “Fortune’s Formula” is published, many investors are turning to the Kelly Criterion for determining the size of the investment. Unfortunately, most of these investors have not walked through the underlying mathematical derivation or read Ed Thorp’s paper on how to apply the Kelly Criterion in the stock market.
There are many fallacies when using the Kelly Criterion directly in stock trading. Unlike most gambling games, the stock market is too complex and the underlying assumptions of the criterion do not hold.
For example, consider the following problem:
Company A is currently researching 3 different new products. In an upcoming convention, we know that A might announce the launch of one of the new products. We can also estimate the impact of different outcomes on the stock price:
30% increase in A’s stock price if Product 1 is launched. There are 20% chance for this to happen.
10% increase in A’s stock price if Product 2 is launched. There are 15% chance for this to happen.
12% increase in A’s stock price if Product 1 is launched. There are 25% chance for this to happen.
15%...
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