Soros believes these perceptions control price trends, domestic government regulation and foreign markets. He is also arguably one of the greatest financial investors working today. In his well-regarded book, The Alchemy of Finance, Soros utilizes his management of the Venezuelan based Quantum Fund to demonstrate and test his own market theories, and offers unique international economic solutions to world-wide financial crises. He also states that investment trades are usually based on biased behaviors or perceptions.
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It has also enabled me to explain and predict events better than most others. This has changed my own evaluation and that of many others. My philosophy is no longer a personal matter; it deserves to be taken seriously as a possible contribution to our understanding of reality.
Understanding what reflexivity is, and how it affects markets and much more is one of the most important fundamental truths a trader can grasp. The idea is centered around there being two realities; objective realities and subjective realities. Objective realities are true regardless of what participants think about them.
Subjective realities on the other hand are affected by what participants think about them. Markets fall into this category. Our collective thinking is what moves markets and produces winners and losers. This means that what we think about reality affects reality itself. And that reality in turn affects our thinking once again. Have I lost you? The company has made little in the way of income in relation to its market cap for the majority of its existence over 15 years but the stock has continued to soar.
This is happening because people formed a number of positive beliefs about the stock. Amazon may look very different today. Forced to focus on profits — like many businesses — Amazon perhaps would not have had the explosive growth its experienced. Maybe it never would have expanded outside of selling books.
Maybe a competitor would have run it out of business. The point is that since markets are reflexive, our beliefs about them directly affect the underlying fundamentals and vice-versa.
And sometimes the reflexive mechanism forms a powerful feedback loop which causes prices and expectations to drastically diverge from reality.
Here is Soros on the subject: Financial markets, far from accurately reflecting all the available knowledge, always provide a distorted view of reality. This is the principle of fallibility. The degree of distortion may vary from time to time. Every bubble has two components: an underlying trend that prevails in reality and a misconception relating to that trend. When a positive feedback develops between the trend and the misconception, a boom-bust process is set in motion.
The process is liable to be tested by negative feedback along the way, and if it is strong enough to survive these tests, both the trend and the misconception will be reinforced. What Soros is saying is that markets are in a constant state of divergence from reality — meaning, prices are always wrong.
Sometimes this divergence is miniscule and hardly perceptible. Other times this divergence is large, due to feedback loop drivers. These are the boom and bust processes. You need to learn how to identify the themes that are ripe for a strong feedback loop to form; where positive perceptions directly boost fundamentals. These are the scenarios where a stock or sector will go parabolic. And Soros again: Usually some error in the act of valuation is involved. The most common error is a failure to recognize that a so-called fundamental value is not really independent of the act of valuation.
That was the case in the conglomerate boom, where per-share earnings growth could be manufactured by acquisitions, and also in the international lending boom where the lending activities of the banks helped improve the debt ratios that banks used to guide them in their lending activity.
Make reflexivity a part of your mental-model for evaluating markets. Want more wisdom from the Trading Greats? Click here to download our free guide. For more about reflexivity theory, be sure to check out the video from our partners at Fallible below! Co-Founder of Macro Ops. More Macro Ops:.
George Soros and his General Theory of Reflexivity
Overview[ edit ] In social theory , reflexivity may occur when theories in a discipline should apply equally to the discipline itself; for example, in the case that the theories of knowledge construction in the field of sociology of scientific knowledge should apply equally to knowledge construction by sociology of scientific knowledge practitioners, or when the subject matter of a discipline should apply equally to the individual practitioners of that discipline e. More broadly, reflexivity is considered to occur when the observations of observers in the social system affect the very situations they are observing, or when theory being formulated is disseminated to and affects the behaviour of the individuals or systems the theory is meant to be objectively modelling. Thus, for example, an anthropologist living in an isolated village may affect the village and the behaviour of its citizens under study. The observations are not independent of the participation of the observer.
Reflexivity (social theory)
The purpose of this thread is for others to learn more about Reflexivity and also to enhance my understanding of it too since through recent Google searches and reading articles it appears to be a misunderstood concept or not understood at all. We are all part of reality. Included in this reality, clearly, is everything we recognise. However, we are also thinking beings, so therefore our thoughts are also part of this reality, however since our thoughts do not always correspond to the facts ie are not reflected in reality these are best considered as the subjective aspect of reality. Now our minds really have two modes, or functions, if you like, one is to understand reality, that is cognition or the cognitive function, the other is to influence reality, that is to manipulate or the manipulative function. In order that we can operate in reality we need to use our cognition in order to try and understand it.