The "Austrian" Approach to Investing

A few years ago, I started to dabble in the theory and practice of finance and basic investing. I read many books on the subject, and although it was fascinating reading, there were always some nagging doubts in the back of my mind regarding some of the key assumptions and philosophical approaches adopted by the authors of those books. Their ideas -- based heavily on the theories of mainstream academics -- seemed a little too neat and Platonic, isolated from the messy and uncertain world of human events.

Soon after being introduced to the Austrian School of economics, I began to wonder what this science of human action -- praxeology -- had to say about investing (besides the obvious and incessant two-word investment advice: "Buy gold!"). What I wanted to know was not whether there are particular Austrian tricks or tactics for investing, but whether there is an overall Austrian approach to investing. There were a couple of articles on the Mises Institute's web site that hinted at such a thing, but they weren't quite what I had in mind.

Then, about a week ago, I noticed a podcast in the Mises Institute's media section entitled "The Development of an Austrian View of Investment." Bingo! In that 30-minute podcast, Richard Grimm summarizes Ludwig von Mises's theory of investing as described in his 1957 treatise Theory and History and adds his own observations from his experience in the financial industry.

Grimm begins by pointing out the three main approaches to investing that one finds today: (1) technical analysis, (2) quantitative analysis, and (3) fundamental analysis. I will summarize what he said regarding each of these three approaches, injecting a few of my own comments along the way.

Technical Analysis

Technical analysis consists of looking at price charts to find patterns that supposedly determine the future direction of the market. Different patterns mean different things: the "dead cat bounce," the "Elliot wave principle," the "Hikkake Pattern," "oscillators," and so on. As human beings, we all tend to look for patterns, but Grimm points out that the problem with technical analysis is that it uses black-box methods that have no theory behind them. It's the modern-day financial equivalent of reading fortunes from tea leaves or oracle bones. It's numerology for investors. Those who use technical analysis often succumb to the "problem of randomness": if they are temporarily successful, they may think their approach is correct when in fact they are probably just lucky.

Mises pointed out that human action is not deterministic, but teleological -- determined by freely chosen goals and actions based on those goals. Technical analysis fits into a deterministic, not teleological, framework. Nevertheless, some Austrian economists embrace technical analysis for reasons Grimm cannot figure out. (Maybe it's just a guilty pleasure, like a world-class body builder singing Bette Midler songs in the shower.)

Quantitative Analysis

Quantitative analysis uses mathematical modeling and econometric applications to find investment opportunities. There are countless ways of quantitatively analyzing markets, but they ultimately amount to programming a mathematical model into a computer and then letting the computer make the investment decisions.

Modern Portfolio Theory (MPT), which includes the Capital Asset Pricing Model (CAPM) for estimating the prices of financial assets like stocks, is based on the assumption that the logarithm of price changes in the market follow normal distributions (bell curves). But various people, including famous mathematician Benoit Mandelbrot and financial writer Nassim Nicholas Taleb, have shown that price changes in the market do not follow normal distributions at all. Whereas normal distributions have "skinny tails," meaning the probability of a large deviation from the mean drops off rapidly with the size of the deviation, real-world asset price distributions have "fat tails," meaning the probability of extreme or even catastrophic deviations from the mean is disturbingly high. Moreover, those "fat-tailed" distributions are not well behaved. They often exhibit quasi-fractal behavior. Another failing of MPT noted by Austrian economists is that it totally ignores the role of the entrepreneur. Entrepreneurial action affects the cross-correlations between different assets, which means the MPT "optimizers" that use them can become unstable. For these and other reasons, all of the investment methods based on MPT are severely flawed.

A common practice in quantitative analysis is to "backtest" one's mechanical, model-based trading system on historical market data. The idea is that if the system is successful on past data, it is likely to be successful in the present and future as well. But Warren Buffett succinctly explained in a recent Berkshire Hathaway shareholder report why the backtesting approach is seriously flawed: "If merely looking up past financial data would tell you what the future holds, the Forbes 400 would consist of librarians."

Surprisingly, despite MPT's well-known fatal flaws, it has made its way into how a lot of financial assets are managed these days. For example:

• Uniform Prudent Investor Act of 1992: If you're running a pension fund in a state that has adopted this act (44 of 50 have), you are required by law to use MPT to manage your assets.
• Pension Protection Act of 2006: Businesses running pension plans or 401(k)s have two choices: They can either (a) use an advisor who has a Certified Financial Planner (CFP) credential and is paid by fee rather than commission, or (b) use an MPT optimizer model.
  

A popular outgrowth of quantitative analysis and MPT is passive investing, which emphasizes diversification above all else. The typical example is to buy an index mutual fund, which buys and holds hundreds or even thousands of securities to track a broad market index rather than pick or actively trade securities in an effort to "beat the market." While index funds do have some definite advantages over actively managed funds, such as low expenses, low portfolio turnover, and returns guaranteed not to be below (nor above!) average, their implicit assumption that more diversification is always better may be their Achilles' heel.

Pursuing extreme diversification assumes that the Efficient Market Hypothesis (EMH) is basically correct. The EMH says that markets quickly and accurately reflect known information, so to that extent, the asset's price is always "right" -- only unanticipated information causes prices to be temporarily "wrong." And because savvy professional investors will pounce on that unanticipated information such that the asset's price will be "corrected" incredibly quickly, ordinary investors don't stand a chance of consistently identifying and taking advantage of undervalued or overvalued assets. Some of your attempts may be successful, but most will not since your competition (the people you are trading with) are much more experienced and skilled than you are. So on average, trying to "beat the market" will in the long run result in below-market returns. Therefore, why not just guarantee oneself market returns by randomly selecting a large basket of diverse stocks and holding onto them (more or less what an index fund does)? That's the EMH-inspired Ode to Diversification.

Austrian economics is not compatible with the EMH. The big problem with EMH is its assumption that only unanticipated information presents investment opportunities. It denies the possibility that known information may not be "correctly" factored into the price of an asset. Austrian economics recognizes that people's actions are based partly on subjective valuations, not purely objective data. Different people process and react to information in different ways -- often in very different ways. People can have any number of goals, motivations, desires, preferences, fears, biases, weaknesses, etc. Because of this, it is possible that the current price of a particular asset may not be "right" at all. It could be, for example, that most people are motivated in some way to believe that its price is right, or maybe most people's understanding of economics is insufficient to allow a better estimate of its price. Austrian economics recognizes people as unique, subjective, goal-driven, acting beings. EMH assumes they are robots.

Fundamental Analysis

Fundamental analysis is stock picking. In Theory and History Mises defined the thought process of investing as thymology, the science or philosophy that underlies fundamental security analysis. Thymology is an offshoot of introspection, similar to the methods used in history and natural psychology. At its core is knowledge of human valuations and volitions. Picking stocks via fundamental analysis is the Austrian approach to investing.

Thymology, or security analysis, proceeds in four steps:

1. Study historical data and events
2. Identify key factors that influenced past events
3. Integrate current information into the analysis
4. Synthesize scenarios to evaluate future courses of action

This means an "Austrian" investor considering a given firm would attempt to gain an understanding of its business (financial statements, management, organizational structure, etc.) and the environment in which it operates (geography, competition, economic and political climate, currency, etc.) before making a decision to buy, hold, or sell. An Austrian perspective, especially knowledge of Austrian business cycle theory, should give an investor a distinct advantage here.

The wise old investors who have advocated a passive approach (including the legendary John Bogle, founder of The Vanguard Group) have been right about emphasizing low expenses and sticking to an investment plan despite temporary fluctuations, but could they have led us somewhat astray by overemphasizing diversification? In a world of general insanity, the Austrian approach to investing is about finding the opportunities that most people are too crazy to notice. Too risky, you say? Not if your view of reality is clearer than most. Gambling is one thing; taking a calculated risk based on solid economic understanding applied to a careful assessment of human motives and actions is quite another.

Investing in a broadly diversified U.S. index fund during a protracted (5+ years) U.S. bear market is like hunkering down and holding on for life while a tornado passes through the neighborhood. That's one way to do it, I guess. A better strategy might be to get out of the tornado's way.