## Can you win money on a bad bet?

I'm just now learning about the Kelly betting system, and I can't wrap my mind around the result that sometimes you should bet a fraction of your money on a bet with negative expected value. Here is an application of the system when you can bet a fixed fraction on any combination of mutually exclusive outcomes, reinvesting your winnings (if any) each time:

The same four horses run a long series of races on the same track. You know from tracking past results for a long time that the win percentages for the horses are

horse 1: 28%
horse 2: 55%
horse 3: 15%
horse 4: 2%

A bookmaker offers the following odds on the horses:

horse 1 at 3:1
horse 2 at 1:1
horse 3 at 5:1
horse 4 at 7:1

If past winning percentages can be taken as the probability that a horse wins, then bets on horses 1 and 2 have positive expectation, while bets on horses 3 and 4 have negative expectation. So you would think one would bet on horse1, or maybe horses 1 and 2, avoiding 3 and 4. But according to the Kelly strategy you do best in the long run if you bet 22% of your current wealth on horse 1, 43% on horse 2, and 11% on horse 3. The remaining 24% is not bet. I simulated this strategy and it works, beating strategies where you don't bet on horse 3. I understand the mathematical derivation of the formula, but I don't understand how it could be true. It is just too counterintuitive. Any thoughts?

Also, notice that there is a "take", in the sense that the odds add up to more than 100%. So there are no cancelling bets in which you get back exactly what you bet, no matter what the outcome.

Recognitions:
 Quote by techmologist Here is an application of the system when you can bet a fixed fraction on any combination of mutually exclusive outcomes, reinvesting your winnings (if any) each time:
The key words here are "mutually exclusive". In other words, in any one race, you can only win one of your bets, and if there are no other horses in the race you are guaranteed to win one of the 4 bets (but of course you might not win enough to cover the cost of making all four bets).

Your simple "avoid negative expectations" strategy ignores those facts, and allocates your money as if each of the 4 horses is running in a different race. In that situation, you could have any number of winnning bets from 0 to 4.

 Yeah, that's true. I guess it would be an example of hedging, right? I was familiar with the idea of betting on negatively correlated events to reduce the variance, but I was still thinking that both bets needed to have positive expectation for the result to be better than simply betting on the outcome with the greatest expectation by itself. This idea of betting on something with negative expectation still seems counterintuitive to me.

## Can you win money on a bad bet?

 Quote by techmologist I'm just now learning about the Kelly betting system, and I can't wrap my mind around the result that sometimes you should bet a fraction of your money on a bet with negative expected value. Here is an application of the system when you can bet a fixed fraction on any combination of mutually exclusive outcomes, reinvesting your winnings (if any) each time: The same four horses run a long series of races on the same track. You know from tracking past results for a long time that the win percentages for the horses are horse 1: 28% horse 2: 55% horse 3: 15% horse 4: 2%
I can't address the specifics of your abstract mathematical problem. But I can offer some practical advice.

The past performance of horses reveals much less than you'd think. It's common for owners and trainers to hold back a horse in a series of races to build up the price in some future big-stakes race. In other words one of the tricks of the trade in professional horse racing is to make horses look worse than they really are.

The other interesting thing you said is that the bets are placed with a bookmaker. That introduces another element.

At the track, the odds are set via pari-mutual betting. All the bettors' money goes into a pool, and the pool is split by those betters holding the winning tickets. Of course the pool's paid out after the state, the racing association, the track, and who knows who else gets their cut. I think around 85-90% of the pool gets paid out. So on the one hand, over the long term the odds are against you just based on the healthy chunk of cash raked off by the government and private entities.

But given that, this is a very fair betting system. The odds directly reflect buyer sentiment. It's literally a perfect market.

But when you go to a bookmaker, you're just dealing with some guy who a) makes up his own odds according to his whims and typically to his benefit; and b) is probably doing something illegal, unless you're at a sports book at a legal casino.

So if you're just doing a math problem, feel free to ignore my comments.

But if you are planning to spend any of your money on this, you'd be better off hanging around at the race track rather than studying probability theory. There's a lot more to horse racing than statistics.

 Quote by SteveL27 ...But if you are planning to spend any of your money on this, you'd be better off hanging around at the race track rather than studying probability theory. There's a lot more to horse racing than statistics.
I'd like to do both, really. Are you trying to tell me I can't have it both ways? Thank you for your input, though. The abstract mathematical problem that I put forward in the first post is very unrealistic, I agree. But I'm hoping that even a toy problem like that can increase my intuition about gambling/investing.

As someone who gambles, don't you think it is strange that there are situations where you should bet when according to the payout and the chances of winning, you are getting the worst of it?

 Blog Entries: 2 Maybe for gambling, but if you view investments as some sort of gamble, then it makes perfect sense. Kelly Criteria ends up being fairly important in investment theory, and is often a quick and nifty way to add diversity. Compared to a lot of mutual funds, you tend to have a fairly good chance of making a fairly decent return using Kelly's Criteria.

 Quote by MarneMath Maybe for gambling, but if you view investments as some sort of gamble, then it makes perfect sense....
Can you explain a little how it makes perfect sense? I don't make any distinction between gambling and investing, so it doesn't make sense in either context to me. I only know that it works somehow. And I can follow the individual steps in the mathematical derivation. But I don't have the insight.

The only practical difference I see between gambling and investing is the size of the markets. For the Kelly criterion to apply, you need to be able to make arbitrarily large bets without completely destroying the favorable situation, or running into some kind of maximum bet limit.

 Blog Entries: 2 I just want to make something very clear, when I say make perfect sense, I don't intend to imply that you can come up with Kelly's Criteria from an investment perspective, or that Kelly's Criteria is the end of all investment strategies for everyone. When I say, it makes perfect sense, you have to look at how investors invest. The idea is this. When you invest, you can different routes you can take, you can put all your money in a stock and hope for it to raise or you can put it all in a bond and know you'll receive a return(risk-free alternative.) More than likely you will choose a mix between these and various other options out there. What Kelly Criteria allows you to do is quantity how to hedge your bets. Assuming a symmetric continous probability distrbution, you can find the optimal way to disturb your funds. In fact, you can even use it to determine when a short sell and or long buy should happen. Overall, it's a useful too, as I said before, to disverify yourself and gives you a reasonable way on how to diversify based on your history. Is it perfect, nope. The market is not symmetric, there exist randomness and violatity, and it probably won't make you richer than your wildest dreams, but it serves its purpose to mitigate possible losses, while still producing growth.

 Quote by techmologist I'm just now learning about the Kelly betting system, and I can't wrap my mind around the result that sometimes you should bet a fraction of your money on a bet with negative expected value. Here is an application of the system when you can bet a fixed fraction on any combination of mutually exclusive outcomes, reinvesting your winnings (if any) each time: The same four horses run a long series of races on the same track. You know from tracking past results for a long time that the win percentages for the horses are horse 1: 28% horse 2: 55% horse 3: 15% horse 4: 2% A bookmaker offers the following odds on the horses: horse 1 at 3:1 horse 2 at 1:1 horse 3 at 5:1 horse 4 at 7:1 If past winning percentages can be taken as the probability that a horse wins, then bets on horses 1 and 2 have positive expectation, while bets on horses 3 and 4 have negative expectation. So you would think one would bet on horse1, or maybe horses 1 and 2, avoiding 3 and 4. But according to the Kelly strategy you do best in the long run if you bet 22% of your current wealth on horse 1, 43% on horse 2, and 11% on horse 3. The remaining 24% is not bet. I simulated this strategy and it works, beating strategies where you don't bet on horse 3. I understand the mathematical derivation of the formula, but I don't understand how it could be true. It is just too counterintuitive. Any thoughts? Also, notice that there is a "take", in the sense that the odds add up to more than 100%. So there are no cancelling bets in which you get back exactly what you bet, no matter what the outcome.

It seems to be a sort of hedging, where the idea is to reduce the variance. Reduced variance is often called reduced "risk" Note that by this definition a bet that is a certain loser has no risk, because it has no variance.

In gambling in casinos and racetracks your expectation is always negative, and there is usually no system to beat it. If there were, the casino or racetrack would not be in business. To make things worse the casino or racetrack also has an incentive to cheat, and is unlikely to get caught. Recently a big online poker company got caught stealing millions from their customers, so yes, it surely happens.

It is possible to make money in games of skill like poker. I used to hang out (virtually) with people who had done this. They ALL agreed that it was a losing game. There were two scenarios. Either you went bust, or you caused other people to go bust and had wasted your life playing poker. So in the end you could not win no matter what. Some day someone you busted is going to go back to his hotel room and shoot himself dead.

If this sort of think interests you then investing in stocks seems like a better deal, as overall there is a positive expectation. But paradoxically, small players also tend to lose all their money even with a small positive expectation.

To sum it all up: in the long run you are CERTAIN to lose all your money if you persist in making bad bets. The appeal of such things has always been a mystery to me. I guess people like the excitement. Losing gives them an emotional kick, and they are willing to pay for that.

Okay. Let's take stock of what has been learned:

1) I shouldn't gamble because for one person to win, someone else must lose.
2) I shouldn't study math because it's a waste of time.

and more to the point

3) The Kelly system can be useful for investing because it helps you diversify.

I don't want to argue against any of these observations. Each is undeniably true and admirable in its own way. But none of them answers my question: It is downright surprising to me that when you have several bets to choose from, some of which tend to gain money in the long run and some of which tend to lose money, that sometimes you do best by betting on the "good bets" and one of the "bad bets". Better than you would do if you spread your money out among the good bets (which are themselves negatively correlated) and left the bad bet alone. This is really so obvious to everyone else? John Kelly, who was an early advocate of the Kelly system, thought it was noteworthy enough to remark in his paper:

 Quote by Kelly, next to last page It should be noted that...some bets might be made for which...the expected gain is negative. This violates the criterion of the classical gambler who never bets on such an event.

 Quote by AlephZero The key words here are "mutually exclusive". In other words, in any one race, you can only win one of your bets, and if there are no other horses in the race you are guaranteed to win one of the 4 bets (but of course you might not win enough to cover the cost of making all four bets).
But that last part in parentheses is the whole point. My (evidently wrong) intuition says that the consolation of knowing that you will win at least one of your bets does not make up for the fact that you are losing money on a losing bet. Yes, when all the "winning bets" fail to pay off, your "losing bet" comes through. But I still find it hard to see how that could ever compensate for all the money you have to throw away on the losing bet most of the time. But somehow, something similar to that happens in the example I gave above (you bet on 3 horses, not all 4). It works, and I don't get it.

 Quote by techmologist But that last part in parentheses is the whole point. My (evidently wrong) intuition says that the consolation of knowing that you will win at least one of your bets does not make up for the fact that you are losing money on a losing bet. Yes, when all the "winning bets" fail to pay off, your "losing bet" comes through. But I still find it hard to see how that could ever compensate for all the money you have to throw away on the losing bet most of the time. But somehow, something similar to that happens in the example I gave above (you bet on 3 horses, not all 4). It works, and I don't get it.
This reminds me of the investor and writer Nassim Nicholas Taleb, who as an investor, made his living betting on "Black Swan" events ... events that are extremely unlikely, but that pay off hugely when they come in.

As an investor, Taleb would come to work every day, place his trades, (which invariably lost a small amount of money every day), and spend the rest of the day working on his mathematical theory of making money from extremely unlikely events.

Every so often, one of those events would happen. All the conventional investors would get killed, and Taleb would collect.

http://en.wikipedia.org/wiki/Nassim_Nicholas_Taleb

You might take a look at his books. One is called Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets.

http://www.amazon.com/Fooled-Randomn.../dp/0812975219

and the other is The Black Swan: The Impact of the Highly Improbable.

http://www.amazon.com/The-Black-Swan.../dp/081297381X

If I'm understanding you correctly, this is the phenomenon you're talking about. I'm not sure if Taleb's Black Swan events have a negative expectation. But typically they're regarded as so unlikely that nobody bothers to calculate them at all.

Also what you're saying reminds me of hedging. Investors buy stocks and then buy options against the stocks. If the stocks go up, the options are like unused insurance. If the stocks go down, the options cover the loss.

Actually just think of car insurance. It's a terrible bet for the buyer. The insurance companies make sure of that! But you still buy car insurance. You need to insure against a rare outcome.

Now we are getting somewhere. I'm glad you brought up Taleb. I read The Black Swan a couple of years ago and would benefit from reading it several more times. Haven't gotten around to Fooled By Randomness yet.

Yes, that does seem similar to what I'm talking about. But I assumed when I was reading Taleb that his bets actually had a positive expectation simply because they are so profitable when they finally pay off. At that point I had never read Kelly's paper (linked to in my previous post), so it was "obvious" to me that any bet that you can consistently make money with must have a positive expectation. I am surprised that there are exceptions to that rule, however unlikely such a situation may be in the real world.

I like the insurance example. I have car insurance, but I'm not hoping I'll get in a wreck just so I'll get my money's worth :)

 And as for the hedging, I have been accustomed to thinking of hedging as something you do to sleep better at night. You give up some of the profitability to reduce risk, because people usually don't like to be exposed to huge losses even when the expected value is high. But in my example above, the "hedge" actually maximizes the long-term growth rate. This is the part that is surprising to me. Maybe I am just unsophisticated. Compared to this, the Monty Hall problem seems easy to grasp. However, I was exposed to that problem at a younger age (as homework), so I may have missed out on the opportunity to be wowed by it.
 So let me get this straight, if you have a market with; 1/1 3/1 5/1 7/1 and you bet on horses 1+2 then you get a 0.75 overround and a 55+28 = 83% strike rate. Throw in horse 4 and now you have a 0.875 overround and an 85% strike rate which makes it unprofitable. Ok. 1. Your market is crap. The overround for it is 104% and a typical bookies will have it set at around 114% 1/1 2/1 4/1 8/1 (114%) This is a better book, use this. 2. Horse strike rates are generally much lower than the odds suggest! There is a website (google it, i forgot the name) which tracks data from all of the horse races in the uk. I recall seeing that horses with an SP of even money have around a 45% strike rate. Your strike rate figures may be overestimated. 3. If you are right with those strike rate figures then the 1/1 horse will be that price (despite winning 55% of the time) because other people don't fancy the horse! There may be a number of factors you fail to consider and thus a situation where you believe you have positive expectation actually ends up in you having significantly negative expectation. 4. You still have to get over that overround figure! 114% is a large edge for the bookies... Using my new book above the overround for horses 1+2 is 0.8333 and their strike rate is 83%, so by simply making a more realistic book I have made it pretty much break even. DON'T FORGET YOUR RATHER GENEROUS STRIKE RATE FIGURES!!! I just read those figures more as probability of winning rather than strike rate in previous races. Even so, getting 55% for a 1/1 horse is buying money and should be encouraged wherever possible!! 5. Even if you think you can read the stats, don't forget that all the bookies are in regular contact with each other when it comes to setting prices. They also employ people who sit there trawling through even stat possibly just to make as tight a book as possible. Horses are usually subject to guide prices which use stats, but admittedly the punters have more control in the prices. Suffice to say, if a horse with a 55% chance of winning is running at 1/1 then you take it! Realistically this horse would be priced at around 1/2 or 8/13 I mean ok if you can find situations like this then bloody well go for it! With a book of 104% you could probably make a bit of money on betfair or any other betting exchange with ease. They just don't exist :p:

Your intuition is entirely correct. This example makes no sense. So let me mutate it into a situation where it DOES make sense.

Suppose you have a thousand dollars, and are flipping coins with some guy who has a million dollars. You flip coins and make one dollar bets until one or the other goes bust. The expectation in both cases is zero, but the distribution is different. Joe Sixpack as one chance in a thousand of making a million dollars, and Daddy Warbucks 99.9% chance of making a thousand dollars.

As an even more extreme example, consider that you have one dollar, and are flipping coins with God, who has infinite dollars. Every time you win, you double your bet. Your expectation from this game is infinite! Really! But you have zero chance of winning that infinite amount of money. The point of this is that a bet with infinite positive expectation can actually be a sure loser, so it is always a good idea to use a bit of common sense in applied mathematics.

As for the horse race where you are betting a trivial amount then the hedging strategy makes no sense at all. Hedging comes in when large amounts of one's net worth are bet. Someone with a million dollars who is betting the entireity of that amount has a very different attitude. The most important thing is to not lose the entire thing and become destitute. So one will pay to protect oneself against such things.

In modern portfolio management one may be "investing" billions of other people's money. Most people don't like to see wild fluctuations in the price of their assets. So such fluctuations are often called "risk." It is simply assumed that all investments have a positive expectation, then there are small investments with negative expectation called "insurance." Supposedly this allows higher return with minimal risk. This fallacy was perhaps the primary cause of the 2008 financial meltdown, which was a combination of fraud and misapplication of basic statistics by economists.

SO, if you are betting a sum of money that would hurt to lose, then this hedging strategy makes sense. If you were betting your entire net worth, then you would certainly bet on that 2% dark horse as well.

----

Often in economics one reads about risk-return. The idea is that investments with higher variance ("risk") have higher expectation ("return.") This is not true. There are plenty of just plain bad investments in this world.

As for this Black Swan's thing, the reason that he could make money was not that the investments were high risk. He could make money because the investments were undervalued. Now that the news is out the price will very likely rise and his return drop.

 Quote by techmologist And as for the hedging, I have been accustomed to thinking of hedging as something you do to sleep better at night. You give up some of the profitability to reduce risk, because people usually don't like to be exposed to huge losses even when the expected value is high. But in my example above, the "hedge" actually maximizes the long-term growth rate. This is the part that is surprising to me. Maybe I am just unsophisticated. Compared to this, the Monty Hall problem seems easy to grasp. However, I was exposed to that problem at a younger age (as homework), so I may have missed out on the opportunity to be wowed by it.
Well, I just plain don't believe it. I think your intuition is correct and betting on horse three reduces your expectation. So if you want to contend otherwise you are going to have to show me this mysterious math. It only make sense if you introduce risk of bankruptcy.

 Hi there! OP describes a situation where the Kelly-optimal strategy includes making a bet with negative expectation, and seeks to get some intuitive understanding of this interesting fact. Lets look at a somewhat simpler example. Suppose you can get 2 to 1 on an event that is 50% likely to happen. The Kelly criterion will tell you to bet a quarter of your bankroll on this (but it really doesnt matter how much). Now suppose you also can get 0,9 to 1 on the opposite outcome. This bet will have negative expectation. But it is surely better, in the Kelly sense, to make a surebet with your remaining money on the two outcomes. So we have a situation where the making a negative EV bet is obviously included in the Kelly strategy. Now, you may say this is different from your example, since there was a "take" in your case, and you didnt have the option of making a surebet. OK, lets assume in my example that the bookmaker also gives odds, say 3 to 1, on a third outcome which you happen to know will not happen. Will that change your betting strategy? (no) Is there now a "take"? (yes) If you are still not happy, lets assume the third option has some microscopic chance of happening anyway. Will that change your betting strategy? (yes, but only very slightly) Now we have essentially your situation, and hopefully your intuition has improved.

 Tags betting, kelly criterion, parimutuel