N N Taleb- Miscellaneous Lectures 3

1 Introduction to Gambler's Ruin

1.1

GAMBLER'S RUIN

Say you have the edge in your favor in a given game, albeit a small one, like 51%
against 49%. You have a finite capital and want to take advantage of the edge to
its fullest extent. There exists a gambling system that eliminates the risk of hitting
a point of cumulative losses that can correspond to virtual bankruptcy
(bankruptcy for a financial operator is not determined by negative wealth but by
its dropping below a predetermined threshold). Eliminating such risk the operator
can go on quietly transforming the edge into hard dollars.
The link between finance and gambling systems, however, needs to be considered
with great care. It is not easy to consider the market like a dice or a coin being
tossed because the outcomes are not discrete. Making the outcomes continuous
require distributional assumptions.
The probabilities in finance are not observable, not easy (or possible) to estimate;
they are (extremely) subjective beliefs more than anything. Bets in general are not
finite, except with the stop-loss strategies, which , we all know, can backfire quite
heavily (as it did with the portfolio insurance programs in 1987). This concept is
applicable to finance, under some liquidity and transaction cost restrictions.
Before examining the optimal betting policy I will provide an exposition of the
gambler's ruin problem.
1.1.1 The Feller Exposition
For the first formal exposition of the problem, see Feller (1950). Feller glued
together the collection of ideas ideas about the random walk that prevailed since
Bachelier (1912). The idea is as follows: Take a gambler betting a fixed quantity
with p probability of winning and p probability of experiencing a loss.
Take an initial wealth Wt at times t. The gambler will gamble 1 unit against one
adversary indefinitely so that the game terminates in the event of his ruin W=0 or

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the ruin of his adversary, which would correspond to taking away his own wealth.
This would be W = Wmax. Note that is the stopping time of the strategy and that
the payoff Wmax can also be interpreted as the reverse ruin, i.e. the attainment of
satisfactory wealth that allows for a Florida retirement.
With p the probability of a win and 1-p the probability of a loss per Bernouilli
toss (with outcome +1 and 1), assume pw and qw the probability that the operator,
starting with wealth W, would reach the set goal and total ruin respectively.
qW = p qW+1 + (1-p) qW-1
given that the operator starting with wealth W has a p probability of increasing his
wealth by 1 to W+1 and q of decreasing it by the same amount.
Setting boundary conditions q0=1 and qWmax=0, the following solution obtains
when p ,
qW =

WMax

1 p W

p
W
1 p Max
1

1 p

which, when p , becomes

qW = 1 W/WMax
and, when the game is unbounded, i.e. WMax becomes
qW = (1/p - 1)W when p>

and
qW = 1 when p
which we can see guarantees ruin should the gambler not have a very close
maximum wealth that would allow him to cash-in and move to Florida.
Now when the gambler does not bet 1 unit, but a fraction of his total wealth , ( )
can be rewritten as:
qW = (1/p - 1)W/ when p>
The expected time to bankruptcy can be calculated in a similar manner as follows:

N N Taleb- Miscellaneous Lectures 5

W = p W+1 + (1-p) W-1 + 1

When p , the following solution obtains

W =

WMax
W

1 2p 1 2p

1 p
1
p
1 p
1
p

W max

and when p =
W= W (WMax W)
It is interesting to see very little further modifications are required for us to
generate laws for the stochastic processes that characterize asset price dynamics.
It suffices to divide the payoff +1 and 1 into smaller and smaller units and
increase the frequency of the betting. Likewise we can get similar results that an
arithmetic Brownian motion that gets absorbed at any level, say 0, will reach it
with probability 1 provided one allows for unlimited time.
1.2

MYOPIC POLICIES: THE KELLY CRITERION

1.2.1 The Kelly Criterion

Kelly(1956) was popularized by Thorpe (1962). We can improve on the Feller
problem by varying the bet size as follows.
Assume you know that p> . Starting with an initial wealth W0 you aim at
getting the optimal strategy with WMax unbounded. Take tk=1 if the kth trial is a
win and tk = 1 if it is a loss. We add the following variable: k the bet size at the
kth trial.
Then,

Wk = Wk-1 + k tk
And
WN = W0 + n k tk

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The expected outcome from a policy of a stream of bets {1,2,, N}

becomes
E[WN] = W0 + k (2 p 1)
Two outcomes become possible
1. The hyper-aggressive Route: Go for the maximum position.
Maximizing E[WN] may navely prescribe the policy of using the
highest value of the parameters k in order to maximize the payoffs,
except that these lead to virtually certain bankruptcy.
2. The hyper-defensive Route: Go for the minimum risk. Minimizing
the probability of ruin leads to minuscule , which may be foolish
given that p > .
Making a proportional bet where the betting quantity is a function of the
cumulative accumulation of wealth would be the solution to avert bankruptcy.
This is the strategy first proposed by Kelly (1956). It is called myopic because
the relative bet size is deemed constant throughout, 1 = 2 = n = .
If we select an k that is a constant proportion to Wk-1, say Wk-1
0<<1, then, after n trials,
WN = W0 (1+)win (1-)N-win
WN will remain >0 for all N and win 0.
Kelly chose to optimize the portfolio growth rate,
Wt= (1+g) Wt-1
which, for large N and frequent increments approximates to
WN/W0= Exp{g N}
Thus
Log(WN/W0) = g N
Log[(1+)win (1)N-win] = g N

with

N N Taleb- Miscellaneous Lectures 7

(win Log(1+)+ (N-win) Log(1 ))/N = g

the expectation of g
E[g] = p Log (1+) + (1-p) Log (1-)
The first order condition for the that maximizes the expectation of E[g]
p/ (1-) +(1-p)/ (1+) =0
which has for solution
= 2p-1
and satisfies a negative second derivative
p /(1+)2 (1-p)/(1-)2 <0.
Note that the previous results can be easily extended to games with asymmetric
payoffs, where the gambler has a probability p of winning and 1-p of losing 1.
The optimal fraction becomes
= (1+p) 1 /
But the representation of "betting" units seems too poor. Its application to finance
requires the use of continuous distributions and non-normalized payoffs. It is to
this task that we turn next.
1.2.2 Full Generalization of the Kelly Criterion to Normally Distributed
Variables
Generalizing to a full-fledged variable with bets on R i.i.d. normal variates with
mean t and standard deviation t.
Wt the wealth from the strategy is, as before, Wt = Wt-t (1 + Rt ), yielding WT =
W0 (1+ Ri). We have, as before, WT/W0 = Exp{g T}, hence g =
Log[WT/W0]/N, the growth rate we need to optimize.
Log[WT/W0] N-1 = N-1 Log (1+ Ri), the expectation of which
E{Log(1+ Rt)}= E{ R + 2 R2 + O(R3)}= t + 2 (2 t2+2 t)

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which, for small or t becomes t + 2 2 t

The solution for the first order condition yields the optimal proportion = /2.