Yo Hayek! How Austrian Economics Relates to Investing

As long time LCF Research readers will already know, we at LCF Research have been fans of the work of our friend Terry Arthur since being introduced to it last year. So much so that we have sponsored a re-print of his 1993 pamphlet entitled “The Consumer Failed to Deliver Last Year and Other Fables.” Though it was originally written almost twenty years ago, it has a lot to offer in terms of lessons for today. Terry is a devoted member of the Austrian School of Economics, and his work is an excellent primer on the basic tenets of Austrian economic thinking as they apply to investing. The pamphlet consists of six lessons, presented as fables, which examine various aspects of this thinking (we discussed Fable 1, “Think and Grow Rich,” in September 2010).

Here is another excerpt, this time from Fable 5, “Risk Taking is Rewarding:”

“Some of us may be familiar with the old intelligence test question “If all the red shops in a street are butchers’ are all the butchers’ shops red?” There are no prizes for the correct answer — “it ain’t necessarily so”.

The same question can be put in another form. Consider the motto “nothing ventured, nothing gained”. This is all sweetly reasonable – how can I win money without risking losing a little? But what about this? If “nothing ventured, nothing gained” is true, is “something ventured, something gained” also true? In other words if we have to take risks to gain, are we certain to gain if we do take the risks?

Again, the answer must be no, yet such is the topsy turvy world of financial economics that we are often assured by experts that the answer is yes. Thus equity shares yield higher returns than bonds because they are riskier! But surely anything that is risky is by definition far from certain and may not even be likely.

The proponents of this view must answer a difficult question. Unless we want to play silly games with the English language, US dollars are more risky than UK pounds to someone living in the UK.

Anyone retiring from a pension scheme with a little lump sum to invest to supplement a meagre income will give you the same answer unless he or she is bound for Florida. So US dollars, being riskier, will yield more (on average). Reversing the situation, UK pounds will yield more to a USA pensioner. Oh dear, they cannot both be right (although there are statisticians who say with a straight face that on average both will gain!). Similarly, staying in the UK, conventional gilt-edged securities will be more risky than index-linked securities to some and less risky to others. So which returns more?

......

There are three simple points to make about risk. The first is that it is in the eye of the beholder. Different beholders see different risks in different assets – and validly so. It is this fact that allows buyers and sellers both to gain on a risk-adjusted basis. The second point is that it is most definitely a function of price – not of price variability. The more you pay, the more you can lose. And the third is that it is cheating to ignore the risk in assessing the reward.”

This is only a small sample, but if you think it is interesting, The Consumer Failed to Deliver Last Year and Other Fables is available to purchase on Amazon, Politicos, and Blackwells.

The current economic crisis has certainly re-ignited an interest in Austrian economic thinking. I listened to the “Analysis – Yo, Hayek!,” a radio programme on Radio 4 last night in which the host, Jamie Whyte, examines the work of F.A. Hayek, the founder of the Austrian School and arch rival of John Maynard Keynes. I found the programme to be very thought provoking – well worth a listen. You can find a link to the recorded podcast here.