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Is There Such a Thing as Austrian Investing?

Mises Daily: Wednesday, January 07, 2009 by

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[An audio version of this article, read by Dr. Floy Lilley, is available as a free MP3 download.]

What is Austrian investing? Is the way an Austrian invests different than any other? Can Austrian principles be formed into an investing method? As one who is profoundly interested in the financial markets, I believe these are questions worth asking.

Equity markets have collapsed in value, bond yields are off, real-estate markets are (in many places) in a state of disarray, monetary devaluation through government inflation is a constant dilemma, bailouts occur weekly, and wars and rumors of wars seem to lurk in the distance. Investing of any sort is enough to make one's stomach turn in times such as these. The hole in the backyard and that spot between the mattresses keeps looking better and better.

Given all this, we can say one thing for sure: there is a lot of uncertainty in the world around us. And given enough time in investment and finance classes, you learn that in the end all an asset manager is really good for is managing that uncertainty — managing risk. The appropriate mix of assets in your portfolio will depend on your level or tolerance for risk. An endowment fund, a 35-year-old attorney, a pension plan, and a 65 year old retired professor do not share the same level of risk tolerance; consequently, they will have very different looking portfolios.

Conventional investing today falls into two categories. The first group says it is best to be as diversified as possible (passive investing). One should buy into an index fund (or some other broadly diversified fund) and hold on for the long term. Coupon payments, dividends, interest, and the passing of time will do the job for you. The second group thinks that the best strategy is to outsmart the market (value or growth investing): find out where the market is going to go by forecasting it, and constantly position your portfolio to profit from it.

Problematically, both of these methods address risk from the same perspective. Under each, there is a high probability that on a given day the portfolio will see a small return and a very small probability that the portfolio will show a large return — due to the unexpected.

Austrians know that the future is uncertain and the uncertain is just that — not known or knowable (i.e. unforecastable). Rather than just diversifying (and hoping for the best) or trying to predict the future (with a crystal ball, or a regression), why not use the fact that the future is uncertain as an investing strategy in and of itself? Develop an investing strategy that has, on any given day, a high probability of a small negative return, and a small probability of a very large positive return.

Rather typically, this idea is not original and Nassim Nicholas Taleb of Empirica Lab is already doing exactly this. More famously, Dr. Taleb is the author of Fooled by Randomness and, more recently, Black Swan — both New York Times bestsellers.

For an excellent bit of background information and a better description of his views, see the Mises Daily Article "Fools Put Faith in Data Alone" by James Sheehan. In addition, Dr. Gary North also has a well written (and scathing) critique, "How Mr. Taleb Got Utterly Fooled by Randomness," available at LewRockwell.com. (The latter article is more theological in nature.)

More specifically, Dr. Taleb advocates putting the majority of a portfolio in less-risky-to-riskless assets, and a much smaller portion of the portfolio in extremely risky assets that have a limited downside.

Simply put, Dr. Taleb makes money by only buying options. On most days, the options expire worthless. On a few days, an unexpected shock is realized, the market moves wildly, and large amounts of money are made. This is identical to finding a volatile industry (or equity) and doing a "long straddle" with it: within a narrow trading range, maximum losses are known in advance and fixed, while a large price movement (positive or negative) can show a virtually unlimited profit.

To further explore Austrian investing, one might look at the nature of Austrian Business Cycle Theory: how can the role of the Federal Reserve in setting interest rates, causing shortages and surpluses in the market for loanable funds, the nature of malinvestment, and the inevitable boom and bust that follow, be formulated into a successful investment process?

But as for Dr. Taleb and the nature of risk, what can be more Austrian than an investment strategy that is based entirely in the notion that the future is uncertain and accurately forecasting it is impossible?