Optimization of Kelly criterion portfolios for discrete return distributions.

Copyright (C) 2014 by Magnus Erik Hvass Pedersen

This file is free to use and copy. The author is not responsible for any consequences or failures.

This is intended for educational purposes. For larger return distributions and
more assets you may want to use the implementation in the R language, see link below.

This file's location on the internet:

www.hvass-labs.org/people/magnus/publications/pedersen2014portfolio-optimization.xlsx

Based on the paper:

Portfolio Optimization and Monte Carlo Simulation
Pedersen, M.E.H., Hvass Laboratories, Report HL-1401, 2014
www.hvass-labs.org/people/magnus/publications/pedersen2014portfolio-optimization.pdf

Source-code for the R language:

www.hvass-labs.org/people/magnus/publications/pedersen2014portfolio-optimization.zip

Revision history:
28. May 2014: First version.
Asset Weight 0.71
Asset Returns 12% -5% 9% -13%

Portfolio Log-Return 0.035638 -0.01576 0.026999 -0.04222

Kelly Value 0.001164

Use the optimizer in menu "Data / Solver" to find the asset

weight that maximizes the Kelly value which is defined as:
E[log(1 + Asset Weight * Asset Returns)]

This example has an asset with four possible returns: 12%,

(5%), 9% or (13%). The Kelly optimal bet is about 0.71 (or 71%)
of your portfolio. The rest of the portfolio is held in cash.

You can extend this with more asset returns by typing them in
row 2. Then you have to drag the formula in cell E4 and update
the averaging in cell B5.
Gov.Bond Yield 3%
Gov.Bond Weight 0.45

Asset Weight 0.55

Asset Returns 13% 1% 5% -6%

Weighted Returns 8.5% 1.9% 4.1% -1.9%

Portfolio Log-Return 0.035342 0.008193 0.017432 -0.00846

Kelly Value 0.013126

Use the optimizer in menu "Data / Solver" to find the weights that maximize the
Kelly value which is defined as:
E[log(1 + Gov.Bond Weight * Gov.Bond Yield + Asset Weight * Asset Returns)]

This example has a government bond yielding 3% and an asset

with possible returns: 13%, 1%, 5% or (6%). The Kelly optimal
portfolio consists of about 0.55 (or 55%) of the asset and 0.45
(or 45%) of government bond.

You can extend this with more asset returns by typing them in
row 5 starting in cell F5. Then you must drag the formulas in
cells E7 and E9, and update the averaging in cell B10.
Asset Weight 0.40
Asset Returns 11% -7% 9% -13%
Probability 0.3 0.3 0.2 0.2
Probability Sum 1.0
Average Return 0.4%

Portfolio Log-Return 0.018487 -0.01219 0.015184 -0.02291

Probability Weighted 0.005546 -0.00366 0.003037 -0.00458
Kelly Value 0.000344

Use the optimizer in menu "Data / Solver" to find the asset

weight that maximizes the Kelly value which is defined as:
E[log(1 + Asset Weight * Asset Returns)]

This example has an asset with four possible returns: 11%,

(7%), 9% or (13%). The respective probabilities of the returns
are: 0.3, 0.3, 0.2 and 0.2. The Kelly optimal bet is about 0.40
(or 40%) of the portfolio in this asset and the rest in cash.

You can extend this with more asset returns by typing them in
row 2 and the probabilities in row 3. Then you have to drag the
formulas in cells E7 and E8 and update the sum in cell B9.
 Asset 1 Asset 2
Asset Weights 0.76 0.24

Asset 1 Returns 12% 9% 9% 0%

Asset 2 Returns 5% 10% 15% 0%

Weighted Returns 10.3% 9.2% 10.5% 0.0%

Portfolio Log-Return 0.042535 0.038399 0.043228 0

Kelly Value 0.031041

Use the optimizer in menu "Data / Solver" to find the asset weights that maximize
the Kelly value which is defined as:
E[log(1 + Asset 1 Weight * Asset 1 Returns + (1 - Asset 1 Weight) * Asset 2 Returns)]

This example has two assets. Asset 1 has possible returns: 12%, 9%, 9%
or 0%. Asset 2 has possible returns: 5%, 10%, 15% or 0%. Note that the
returns are dependent in the order listed so if e.g. asset 1 has return 12%
then asset 2 has return 5%. The Kelly optimal portfolio has about 0.76 (or
76%) of asset 1 and about 0.24 (or 24%) of asset 2.

You can extend this with more asset returns by typing them in rows 4 and
5 starting in cells F4 and F5. Then you have to drag the formulas in cells
E7 and E9, and update the averaging in cell B10.
Gov.Bond Yield 3%
Gov.Bond Weight 0.00

Asset 1 Asset 2 Asset 3

Asset Weights 0.89 0.00 0.11
Weight Sum 1.00

Asset 1 Returns 11% 1% 2% -1%

Asset 2 Returns 6% 10% -8% 4%
Asset 3 Returns -3% 4% 9% 2%

Weighted Returns 9.4% 1.3% 2.8% -0.7%

Portfolio Log-Return 0.03920364 0.00575 0.011894 -0.00291

Kelly Value 0.01348507

Use the optimizer in menu "Data / Solver" to find the weights that maximize the Kelly
value which is defined as:
E[log(1 + Gov.Bond Weight * Gov.Bond Yield + Sum(Asset i Weight * Asset i Returns))]

This example has a government bond with 3% yield and 3 assets. Asset 1 has
possible returns: 11%, 1%, 2% or (1%). Asset 2 has possible returns: 6%, 10%,
(8%) or 4%. Asset 3 has possible returns: (3%), 4%, 9% or 2%. The returns are
dependent so if asset 1 has return 2% then asset 2 has return (8%) and asset
3 has return 9%. The Kelly optimal portfolio consists of 0.89 (or 89%) of asset
1 and 0.11 (or 11%) of asset 3; the government bond and asset 2 are not
included in the Kelly optimal portfolio.

You can extend this with more assets by adding more rows. Then you have to
add another asset weight and update the sum in cell B6; update the Solver
settings; update the formula in B12 to include the new asset and then drag
the formula to update all the other cells in row 12; drag the formula in B14 to
update row 14. If you add more asset returns then you also have to update
the averaging in cell B15.