Theory of Reflexivity
George Soros
George Soros is an extremely successful stock speculator and investor. From 1970 to 1980, Soros’s Quantum Fund returned an average of 42.5% per year. Forbes ranked Soros as the 24th wealthiest person in the world in 2004, with an estimated net worth of $7.2 billion.
Soros is famously known for breaking the Bank of England in 1992 when his bearish trades precipitated the fall of the European monetary system. The successful trade earned Soros an estimated $1.1 billion. Soros successfully repeated this trade again during the 1996 and 1998 Asian currency crises.
The Theory of Reflexivity
Soros is less well known for his financial and economic theories. Soros’s central financial theory is the theory of reflexivity. The general idea of the theory of reflexivity is that irrational exuberance, or biases can influence market transactions and create disequilibrium. This can influence not only the market price but also underlying fundamentals. The theory of disequilibrium contradicts the traditional efficient market hypothesis which asserts that markets are rational, informationally efficient, and unbiased.
The theory of reflexivity suggests that in certain cases the activity of the financial markets driven by particpant bias can influence the fundamentals that the market prices are supposed to represent. This results in disequilibrium causing the markets to behave differently than assumed by an efficient market hypothesis.
A key difference between financial markets and other studied and researched natural science is that markets are driven by thinking participants. This thinking and decision making effects decisions made by investors. While investors may utilize facts in the decision making process, the choices are ultimately influenced by biases, emotions, or other factors.
According to Soros, “Reflexivity is, in effect, a two-way feedback mechanism in which reality helps shape the participants’ thinking and the participants’ thinking helps shape reality in an unending process in which thinking and reality may come to approach each other but can never become identical. Knowledge implies a correspondence between statements and facts, thoughts and reality, which is not possible in this situation.The key element is the lack of correspondence, the inherent divergence, between the participants’ views and the actual state of affairs.”
Theory of Reflexivity Examples
The theory of reflexivity is most evident during boom or bust cycles. Soros provides many examples of his theory of reflexivity. An interesting example focuses on equity leveraging. Companies can utilize the irrationally high expectations of investors as a source of demand for a new stock issue. After gaining capital from this stock issue, the companies can apply the capital to business operations to influence growth and earnings per share. This demonstrates an example of how investor bias could influence underlying fundamentals.
Conclusion
The theory of reflexivity seems to parallel the fat tailsconcept. Fat tails are statistical irregularities, in which very low and high values are more frequent than a normal distribution predicts. In markets, fat tails often result from irrational behavior at extremes. For example, during a market down turn, investors’ sell decisions may be influenced by fear and not reflect that actual value of the underlying investment.
Fat tails seem to parallel the theory of reflexivity, but the theory of reflexivity also suggests that investor bias can influence underlying fundamentals. Soros’s theory of reflexivity is very interesting and his amazing speculation success certainly provides him with some credibility.
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