This article isn't going to delve into the mathematics behind the Kelly Criterion; rather, it'll try to discuss some of the strenths and weaknesses of this money management system as well as point out a few related web sites on the internet.
How does the Kelly Criterion Work?
The Kelly system works by leveraging the odds...finding spots where there are overlays and betting a portion of your bankroll based on how much of an overlay it is. By taking into the account the expected rate of return and the risk involved Kelly's utility function maximizes the overall growth of your bankroll. Betting more than the suggested Kelly amount is an undue risk; betting less than the Kelly amount will cause your bankroll to grow more slowly.
Of course, bankroll growth isn't a guaranteed thing. Using the Kelly Criterion successfully requires that you be able to find overlays when they arise and taking advantage of them. So to use the system properly, you need to be able to accuratly assess each horse's chance to win a race and you need to be able to do it better than the crowd as a whole. If you can do this, the Kelly system is the ultimate method for taking advantage of overlays.
So using the Kelly Criterion properly means that you'll need to create your own morning line ahead of time to get an idea of how you feel the race is going to shape up. For instance, let's look at an imaginary three horse race; let's assume you've done the handicapping ahead of time and come to the conclusion that horse #1 has a 30% chance to win the race, horse #2 has a 50% chance to win the race and horse #3 has a 20% chance to win the race. However, on the tote board, the crowd has given horse #1 a 25% chance to win the race. Using the Kelly Criterion, you'll be able to figure out what percentage of your bankroll you should wager on the #1 horse. While that may be a simplification of the system, it's essentially how it works, bet when you spot overlays, hold back when you don't.
With the Kelly Criterion, you are always betting percentages of your bankroll so as your bankroll grows, so do your bets. Likewise, when your bankroll shrinks, your bets will shrink. The suggested percentages to wager can vary drastically depending on the expected rate of return on a specific bet, but you'll never find that you'll need to wager your entire bankroll on a single horse, nor a large portion of it unless you spot a huge overlay.
The math behind the system is pretty complicated. Kelly's original paper is all but unreadable to non math majors. Some useful links for figuring out the mathematics of the system and a calculator which will do all the math for you are provided at the bottom of this article.
Part 2 - What are the problems with the Kelly Criterion?
Part 3 - Scaling Back on the Optimal Kelly Wager
