Mauboussin on the Kelly criterion


There is very little in the way of sell-side Wall Street research that is worth your time. However on the buy-side, i.e. Legg Mason Capital Management, Michael Maouboussin, writes particularly well on the role of behavioral finance and investment management.

His most recent piece discusses the Kelly criterion and its role in portfolio management. We touched on the topic in a review of the book, Fortune’s Formula. If you do not have the time, or the inclination to read the entire book, the Maouboussin piece is a good summary. While we do not want to preempt you from reading the piece here is one of his conclusions:

Edge is key. Recall the foundation of Kelly’s model rests on having a view that is different, and more correct, than that of the market. Having an edge requires understanding the market’s perspective. As Poundstone writes, “The stock ticker is like a tote board. It gives the public odds. A trader who wants to beat the market must have an edge, a more accurate view of what bets on stocks are really worth.?

One way for equity investors to think about edge is finding situations where the stock’s rate of return is likely to be higher than the market anticipates. A stock’s excess rate of return is a function of its percentage discount to fair value—the margin of safety—and how long it takes the market to close the price-to-value gap.

We recommend you read the piece to interested readers. You can find a link to all of the “Mouboussin on Strategy” pieces here.


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