Last December I read The Alchemy of Finance by George Soros. Published in 1987 I’m no doubt late to this one… to my credit, in 1987 I was -10 years old.
I have come to find his theories on Reflexivity to be eye opening and a well needed addition to the proverbial tool belt of a trader/market participant. I will attempt to distill the fundamentals here for anyone who may find value.
Out of the gate, George states the concept of market equilibrium has “no relevance to the way financial markets operate.” Stating that to think in those terms would be counterproductive for any trader.
The Concept of Reflexivity:
In Georges words: “In situations that have thinking participants, there is a two-way interaction between the participants thinking and the situation in which they participate. On the one hand, participants seek to understand reality; on the other, they seek to bring about a desired outcome. The two functions work in opposite directions: in the cognitive function reality is given; in the participating function, the participants understanding is the constant. The two functions can interfere with each other by rendering what is supposed to be given, contingent. I call the interference between the two functions ‘reflexivity’.”
“I envision reflexivity as a feedback loop between the participants understanding and the situation in which they participate, and I contend that the concept of reflexivity is crucial to understanding situations that have thinking participants. Reflexivity renders the participants understanding imperfect and ensures that their actions will have unintended consequences.”
The basis being that while nobody has a truly objective/perfect understanding of how the world works, markets where participants contribute to said reality enable a degree of self-fulfilling/self-defeating cycles.
He elaborates that when we act purely as observers of a situation our understanding of the situation does not affect the reality. When we act as participants in a “market” our understanding of the reality (however deluded) has a material impact on the fundamentals of the market and thus changes the reality. “Our actions alter the situation we seek to understand.”
Due to the nature of reflexivity in markets we cannot base our decisions on knowledge. While knowledge can certainly aid as a tool for understanding; “we are confronted with a situation that is inherently unknowable in the sense that what needs to be a fact to make knowledge possible is, in fact, contingent on the participants view of the situation.”
Efficient Markets and Reflexivity
In University they teach Efficient Markets, equilibrium based concepts where instruments are valued to reflect their future cash-flow potential. The concept that market prices are discounted reflections of the underlying fundamentals. While the Universities have moved further away from the 100% efficient market hypothesis toward one of less efficiency, from my experience the reflexive (self-fulfilling/self-defeating) and psychological aspects of markets are mostly ignored. We know that in the efficient market world individuals like Soros could not post average returns above 30% for 3 decades… so maybe this guy isn’t so crazy.
The result of reflexivity and psychology in markets is self-fulfilling and eventually self-defeating cycles where the initial participants perceptions lead to fundamental market changes that in turn lead to confirmation of the initial perception. At the inflection point the prevailing bias is proven wrong leading to the self-defeating process where the change in participants views affects fundamentals which in turn affirms the view. You may conclude that the reason we see booms and busts in financial markets is due to the reflexive nature of participants views affecting fundamentals. Or the spread of participants views of reality and reality itself, as it expands and contracts.
Ray Dalio also endorses the concept of the self-fulfilling and self-defeating process, he focuses on credit cycles in his recent book Big Debt Crises (currently reading). Dalio looks at long-term and short-term credit cycles and identifies feedback loops as well as primary indicators which provide insight into the direction of market forces.
It clearly pays to identify the flaws in markets before they reach an inflection point and the paradigm shifts. We should aim to better understand the nature of markets and hopefully build our systems around the reflexive imperfect nature humans command.
Ive barely touched on the genius Soros presents in his book, would highly recommend to anyone who participates in markets.
“I’m only rich because I know when I’m wrong.” -George Soros
Thanks for reading.