Solved – Maximizing probability of winning on loaded coin

diceprobability

If we have a loaded coin that plays out 75% heads, 25% tails, what would be the best way to bet on the outcome of each of $n$ trials? How could we maximize our probability of winning?

Is it possible to generalize for a coin that's loaded $n:(100-n)$?

Best Answer

In what follows, I will assume you mean someone gives you 1:1 odds on the loaded coin.

You are looking for the Kelly criterion, which states:

$$ f^* = \frac{ b p - q }{ b } $$

where (just copying from wikipedia) $f^*$ is the fraction of your bank roll, $b$ is the fraction payout (in your case presumably $b=1$, i.e. a dollar investment gives you a dollar return if heads is thrown) and $q = 1-p$.

For your example, the fraction the Kelly criterion says to invest is $f^* = .75 - .25 = 0.5$. i.e. The Kelly criterion tells you to invest half of your savings each time you play.

As intuition, you want to make sure you don't invest all your money on a loaded coin as just one bad throw will deplete your savings. Understanding what function to maximize for is what the Kelly criterion is instructive for.

The Kelly criterion requires that you maximize your winnings based on:

$$ p\ \text{ln}(1 + b x) + (1-p)\ \text{ln}(1 - x) $$

Maximizing for $x$ yields the equation for $f^*$ above.

Unfortunately I am a little unclear as to why this particular equation is being maximized as opposed to some other equation. I have heard an information theoretic argument for why this is so (notice that the equation above looks very much like an entropy equation) but, sadly, still remain puzzled.

EDIT:

Well, I feel pretty dumb. As whuber points out in the comments, the Kelly criterion is quite easy to derive. If we assume a you want to invest a constant proportion of your savings at each trial, call it $r$, then your winnings after $n$ trials, $W_n$, for an initial savings of $W_0$, will be:

$$ W_n = (1 + b r)^{p n} (1 - r)^{(1-p) n} W_0 $$

Taking logarithms, noticing that this equation, as a function of $r$, has one maximum, then setting the derivative equal to 0 and solving gives the Kelly criterion formula for $r = f^*$ as above.

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