Kelly Criterion: Avoid Ruin

Nivi: Let’s chat about the Kelly criterion. 

Naval: The Kelly criterion is a popularized mathematical formulation of a simple concept. The simple concept is: Don’t risk everything. Stay out of jail. Don’t bet everything on one big gamble. Be careful how much you bet each time, so you don’t lose the whole kitty. 

If you’re a gambler, the Kelly criterion mathematically formulates how much you should wager per hand, even if you have an edge—because even when you have an edge, you can still lose. Let’s say you have 51-to-49 edge. Every gambler knows not to bet the whole kitty on that 51-to-49 edge—because you could lose everything and won’t get to come back to the average.

Nassim Taleb famously talks about ergodicity, which is a fancy word for a simple concept: What is true for 100 people on average isn’t the same as one person averaging that same thing 100 times. 

Ruining your reputation is the same as getting wiped to zero

The easiest way to see that is with Russian roulette. Say six people play Russian roulette one time each, and each winner gets $1 billion. One person ends up dead and five people get $1 billion. Compare that to one person playing Russian roulette six times with the same gun. They are never going to end up a billionaire—they will be dead and worth zero. So risk-taking—especially when the averages that are calculated across large populations—is not always rational. 

The Kelly criterion helps you avoid ruin. The number one way people get ruined in modern business is not by betting too much; it’s by cutting corners and doing unethical or downright illegal things. Ending up in an orange jumpsuit in prison or ruining your reputation is the same as getting wiped to zero—so never do those things.