Red-Blooded Risk: The Secret History of Wall Street

If Harry Knew Kelly

Let's go back to the counterfactual I suggested earlier. Suppose Harry Markowitz had known John Kelly's work in 1952, four years before Kelly published. Harry might have answered his initial question differently. Why don't investors put all their money in the single best stock? Instead of deciding it's because investors dislike risk, he might have said it's because putting all your money in one stock is overbetting.

In the real world, Markowitz created modern portfolio theory (MPT). It holds that investors care about the statistical properties of their portfolios and act to maximize expected return subject to a risk constraint. Expected return is good, risk is bad, and the investor balances the two.

A Kelly-inspired analogue might have been called investment growth theory (IGT). The claim would be that investors select a portfolio for optimal long-term growth. Investors care about investments, not portfolios, and determine how much to allocate to each based on expected return and variance. There are portfolio effects; your capital allocation decision on each investment depends on your past decisions, but these are pretty small in practice unless you are considering highly correlated assets.

In the IGT world, we would expect an investor to analyze investment opportunities one at a time. Each acceptable investment would be assigned an investment amount, a lot for ...