Analyzing Sequential Betting with a Kelly-Inspired Convective-Diffusion Equation

Abstract

The purpose of this article is to analyze a sequence of independent bets by modeling it with a convective-diffusion equation (CDE). The approach follows the derivation of the Kelly Criterion (i.e., with a binomial distribution for the numbers of wins and losses in a sequence of bets) and reframes it as a CDE in the limit of many bets. The use of the CDE clarifies the role of steady growth (characterized by a velocity U) and random fluctuations (characterized by a diffusion coefficient D) to predict a probability distribution for the remaining bankroll as a function of time. Whereas the Kelly Criterion selects the investment fraction that maximizes the median bankroll (0.50 quantile), we show that the CDE formulation can readily find an optimum betting fraction f for any quantile. We also consider the effects of “ruin” using an absorbing boundary condition, which describes the termination of the betting sequence when the bankroll becomes too small. We show that the probability of ruin can be expressed by a dimensionless Péclet number characterizing the relative rates of convection and diffusion. Finally, the fractional Kelly heuristic is analyzed to show how it impacts returns and ruin. The reframing of the Kelly approach with the CDE opens new possibilities to use known results from the chemico-physical literature to address sequential betting problems.

Keywords

• innovation portfolio
• investment
• bet
• Kelly criterion
• ruin