Legg Mason has released the latest commentary from Chief Investment Strategist Michael Mauboussin (who is also an Adjunct Professor of Finance and Economics at Columbia). In it, he discusses an often overlooked aspect of investing: money management. Being a successful investor over the long term requires finding investment opportunities where you have an analytical edge, but also knowing how much of your assets to invest in that opportunity when it arises. Choosing this amount requires balancing the desire to fully exploit a positive expectation investment with the desire to minimize the risk of ruin, i.e., losing all of your investment capital. Mauboussin looks to the Kelly Criterion, the famous money management strategy employed by gamblers, for help in optimally allocating assets towards investments.

He distills his analysis into four key points:

• Edge is key: you should be investing money in areas of the market where you have an analytical edge over the market at large
• Greater opportunity suggests a larger bet: the greater the edge you have over the market, the more you should invest
• Mean/variance is not the best way to think about maximizing long-term wealth if you are reinvesting your investment proceeds: the standard type of mean/variance portfolio optimization proposed by Markowitz is relevant for one-time financial decisions, but in situations where profits are reinvested, optimizing your geometric mean of returns is better
• Applying the Kelly Criterion is hard psychologically: adhering to the Kelly Criterion means accepting volatile returns — as investors we are risk averse and frequent losses are stressful psychologically, even if they provide the path to maximizing returns

Read the paper here: Mauboussin on Strategy: Size Matters