Resolution
One easy way to dismiss the paradox is to note that Kelly assumes that odds do not change. A Kelly bettor who knows odds might change should factor this into a more complex Kelly bet. For example suppose a Kelly bettor is given a one-time opportunity to bet a 50/50 proposition at odds of 2 to 1. He knows there is a 50% chance that a second one-time opportunity will be offered at 5 to 1. Now he should maximize:
with respect to both f1 and f2. The answer turns out to be bet zero at 2 to 1, and wait for the chance of betting at 5 to 1, in which case you bet 40% of wealth. If the probability of being offered 5 to 1 odds is less than 50%, some amount between zero and 25% will be bet at 2 to 1. If the probability of being offered 5 to 1 odds is more than 50%, the Kelly bettor will actually make a negative bet at 2 to 1 odds (that is, bet on the 50/50 outcome with payout of 1/2 if he wins and paying 1 if he loses). In either case, his bet at 5 to 1 odds, if the opportunity is offered, is 40% minus 0.7 times his 2 to 1 bet.
This is not entirely satisfactory, however. If a Kelly bettor has incorrect beliefs about what future bets may be offered, he can make suboptimal choices, and even go broke. The Kelly criterion is supposed to do better than any essentially different strategy in the long run and have zero chance of ruin, as long as the bettor knows the probabilities and payouts. The fact that it can be frustrated by unexpected new offers is puzzling. It is also puzzling that the Kelly bettor bets more at blended 2 to 1 and 5 to 1 odds than at 5 to 1 odds, and that it is improving odds that lead to the possibility of ruin.
More light on the issues was shed by an independent consideration of the problem by Aaron Brown, also communicated to Ed Thorp by email. In this formulation, the assumption is the bettor first sells back the initial bet, then makes a new bet at the second payout. In this case his total bet is:
which looks very similar to the fomula above for the Proebsting formulation, except that the sign is reversed on the second term and it is multiplied by an additional term.
For example, given the original example of a 2 to 1 payout followed by a 5 to 1 payout, in this formulation the bettor first bets 25% of wealth at 2 to 1. When the 5 to 1 payout is offered, the bettor can sell back the original bet for a loss of 0.125. His 2 to 1 bet pays 0.5 if he wins and costs 0.25 if he loses. At the new 5 to 1 payout, he could get a bet that pays 0.625 if he wins and costs 0.125 if he loses, this is 0.125 better than his original bet in both states. Therefore his original bet now has a value of -0.125. Given his new wealth level of 0.875, his 40% bet (the Kelly amount for the 5 to 1 payout) is 0.35.
The two formulations are equivalent. In the original formulation, the bettor has 0.25 bet at 2 to 1 and 0.225 bet at 5 to 1. If he wins, he gets 2.625 and if he loses he has 0.525. In the second formulation, the bettor has 0.875 and 0.35 bet at 5 to 1. If he wins, he gets 2.625 and if he loses he has 0.525.
The second formulation makes clear that the change in behavior results from the mark-to-market loss the investor experiences when the new payout is offered. This is a natural way to think in finance, less natural to a gambler. In this interpretation, the infinite series of doubling payouts does not ruin the Kelly bettor by enticing him to overbet, it extracts all his wealth through changes beyond his control.
Read more about this topic: Proebsting's Paradox
Famous quotes containing the word resolution:
“The changes in our life must come from the impossibility to live otherwise than according to the demands of our conscience ... not from our mental resolution to try a new form of life.”
—Leo Tolstoy (1828–1910)
“The passions do very often give birth to others of a nature most contrary to their own. Thus avarice sometimes brings forth prodigality, and prodigality avarice; a man’s resolution is very often the effect of levity, and his boldness that of cowardice and fear.”
—François, Duc De La Rochefoucauld (1613–1680)
“We often see malefactors, when they are led to execution, put on resolution and a contempt of death which, in truth, is nothing else but fearing to look it in the face—so that this pretended bravery may very truly be said to do the same good office to their mind that the blindfold does to their eyes.”
—François, Duc De La Rochefoucauld (1613–1680)