Investing Using The Theory Of Austrian Economics

Introduction

Mark Spitznagel, a successful investor specializing in tail hedging for the purposes of risk management, and author of the book, The Dao of Capital, believes that the economy functions according to the principles laid out in the Austrian Theory of Economics. The theory asserts that economies are driven by the actions of individuals, money is created as a consequence of a free market, and natural market forces are sufficient to control the allocation of capital, rate of inflation, and credit cycles. Using these principles as the basis for choosing when to purchase assets and when to sell them, Spitznagel has developed a robust framework for portfolio construction and management that outperforms the returns of the stock market. This is done by assuming the interventions of government and the central banking system distort the processes of the underlying economy but cannot change them in the long run, thus enabling an opportunity to identify where interventions create distortions in prices that will ultimately regress to their true value.

In this post, we will briefly review the theory of austrian economics, explore connections to other areas of science, including the free energy principle, and then close by replicating some of the results mentioned in the book.

Austrian Economics and Free Energy

Recall that Austrian economics states that people are driven to action to achieve goals. The choices of individuals vary and are a function of their goals, which also vary. As mentioned in a prior post, a recent development in the field of neuroscience seeks to explain the dynamics of choices as a function of free energy. Based on an individual's hierarchy of needs, one will seek to minimize the amount of energy expended acquiring the highest ranked need not currently satisfied. Said another way, humans aim to enter and remain in a state of homeostasis by minimizing their free energy and thus avoiding surprises when interacting with the environment. This theory seems to have the potential to unify individual behavior explained from a economics perspective using utility theory with human biology and evolution, a fundamental gap in the field, at least to the best of my knowledge.

Faustmann's Formula

Faustmann's formula gives the present value of the income stream for forest rotation. The formula is used to determine the best time to harvest a forest. In short, the optimal time to cut a forest is when the rate of change in forest value is equal to the interest rate, \( r \), on the forest and land. Mathematically, this is expressed as:

where \(p\) is the unit price of the forest, \(r\) is the discount rate, \( T \) is time, and \( f(T) \) is stock of timber in the forest.

Misesian Stationarity Index

The Misesian stationarity index (MSI) is a measure of expected return on invested capital divided by net-worth. Mathematically, this is computed as:

where \( \mu \) is the geometric mean.

MSI values less than 1 indicate returns on invested capital are less than the value of the asset while values greater than 1 indicate the opposite, that returns on invested capital are greater than the value of the asset.

It can be computed for the United States economy by using data published by the Federal Reserve in row 39 and 40 of table B.103 in the quarterly Z.1 report. The figure below plots the MSI as a function of time beginning just before 1950.

Interpretation

So what is an investor to do based on the value of the MSI? Well, the average, risk averse investor should probably avoid buying stocks when the MSI is less than 1. However, given that timing the market is nearly impossible, it is not possible to know when stock market valuations will return to reasonable levels. A more sophisticated approach is required to enable the investor to invest and remain invested over many values of the MSI.

Tail hedging is a strategy that involves purchasing insurance in the form of out-of-the-money options to protect against large losses in the portfolio. Because the options are out-of-the-money, they are relatively cheap and more often than not, worthless. However, when they become valuable, their value can offset the losses incurred by a significant drops in the stock market.

The strategy is not without its drawbacks. The cost of the insurance can be significant and the investor must be prepared to lose the entire premium paid for the insurance. However, the strategy has been shown to be effective in limiting losses during significant market events, such as the 2008 financial crisis.

Implementing tail hedging can be simple. Most broker dealers will offer access to an options market. To hedge the portfolio, the investor must simply decide how much of their portfolio they wish to protect and over what period of time. Once determined, the investor can purchase the options and begin continuously rolling them over to maintain the insurance and generate returns when the options are in the money. Note that more often than not, the options will expire worthless and the investor will have to use cash to purchase new ones.

In an article from 2015, Spitznagel recommends purchasing options that are 30% out of the money, with an expiration date 3 months into the future. Doing so minimizes the cost of the options and maximizes their return during market downturns. Note that the options can expire worthless so there must be available cash to absorb the relatively small loss and keep the insurance in force.

The article states that this strategy, when implemented with public U.S. equities, can perform as good or better than a traditional 60/40 portfolio but with less volatility, something important for many investors.