Kelly criterion and lottery tickets

Suppose you have a bet which loses money most of the time, but wins a massive amount now and then, how much money should you put on it?

Let’s say the 1 time you win, you win $a for each dollar you bet, and the N times you lose, you lose $b for each dollar you bet. By the Kelly criterion, the geometric average rate of gain if you bet x of your wealth would be

R = (1+xa)(1-xb)^n

Setting \partial_x R = 0, you get

x = \frac{a - nb}{(n+1)ab} = \frac{\left<\mathrm{arithmetic\ gain}\right>}{ab}

Suppose you are asked to flip a coin, and heads you win $3, and tails you lose $1—then n=1, a=2,b=1, and therefore x = \frac{1}{2 \cdot 2} = \frac{1}{4}, i.e., you should bet 25% of your wealth.

If you have a lottery ticket that has a 1 out of 5,000 chance of winning $10,000 that costs $1, and you are only allowed to buy one number, then n=4999,a=9999, b=1, and
x = \frac{5000}{49999 \cdot 9999} \approx 10000^{-1} and you should only bet 0.01% of your wealth at a time.

Conversely, if you were selling a lottery ticket that had 1 out of 10,000 chance of winning $5,000 that cost $1, n = 9999, a = -4999, b = -1, and x = \frac{5000}{9999\cdot4999} \approx 10000^{-1} and you should be trying to have about 0.01% of your wealth at stake.

Related: Do not play the lottery unless you are a millionaire

This entry was posted on Monday, February 1st, 2010 at 6:36 pm and is filed under Uncategorized. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.

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