Application of the Kelly Criterion to Prediction Markets

TL;DR

This paper explores how the Kelly Criterion can be applied to prediction markets, analyzing the effects of misjudgments on portfolio growth using a simple coin-flip model and proposing a modified payout structure.

Contribution

It introduces a novel application of the Kelly Criterion to prediction markets and proposes a modified payout structure to improve investment outcomes.

Findings

Misjudgment of bias affects portfolio growth rate

Miscalculation of investment fraction impacts returns

Modified payout structure offers potential improvements

Abstract

Betting markets are gaining in popularity. Mean beliefs generally differ from prices in prediction markets. Logarithmic utility is employed to study the risk and return adjustments to prices. Some consequences are described. A modified payout structure is proposed. A simple asset price model based on flipping biased coins is investigated. It is shown using the Kullback-Leibler divergence how the misjudgment of the bias and the miscalculation of the investment fraction influence the portfolio growth rate.