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Fortune’s Formula: How the Pros Wager

In: The Adventures of a Modern Renaissance Academic in Investing and Gambling

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  • William T Ziemba

Abstract

The use of log utility dates to the letters of Daniel Bernoulli in 1738. The idea that additional wealth is worth less and less as it increases and thus utility tails off proportional to the level of wealth is very reasonable. This utility function seems safe for investing. However, I argue that log is the most risky utility function one should ever consider using and it is most dangerous. However, if used properly in situations where it is appropriate, it has wonderful properties. For long-term investors who make many short-term decisions, it usually yields the highest long-run levels of wealth. This is called Kelly betting in honor of Kelly’s 1956 paper that introduced this type of betting. In finance, it is called the Capital Growth Theory or Fortune’s Formula. Kelly was working at Bell Labs and was greatly influenced by Claude Shannon, the father of information theory…

Suggested Citation

  • William T Ziemba, 2017. "Fortune’s Formula: How the Pros Wager," World Scientific Book Chapters, in: The Adventures of a Modern Renaissance Academic in Investing and Gambling, chapter 7, pages 69-82, World Scientific Publishing Co. Pte. Ltd..
    • Handle: RePEc:wsi:wschap:9789813148529_0007
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    Keywords

    Financial History; Risk Management; Investment Strategies; Mean Reversion; Risk Arbitrage; Management of Assets;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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