Reflexivity Theory in Stock Trading by George Soros

George Soros, the founder of the Quantum Fund, is one of the most successful hedge fund investors ever. A $100,000 investment in his fund when he started in 1969 would've been worth $150mm by 1994. Soros's most famous investment was when he "broke the bank" in England by betting billions against the British pound on "Black Wednesday" in 1992. Forbes has Soros ranked at 27 in its "richest in America" list with a net worth tipping the scales at $8.5bb.

Soros has always fashioned himself as more of a philosopher than an investor and that his skill as an investor is simply the successful application of his philosophy that he dubbed "Reflexivity" in his book, "The Alchemy of Finance".
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To Soros, the conventional approach is rubbish. Instead of a world of near-identical actors, coolly assessing their economic interests and acting with clear-eyed precision, he sees a world (and markets) governed by passion, bias and self-reinforcing errors. Because fallible human beings are both involved in, and trying to make sense of, this world, they inevitably make mistakes. Those mistakes then feed on themselves in "reflexive" ways that, when taken to extremes, result in situations such as the now-deflating U.S. housing bubble.

Standard economic theory is flawed, Soros says, because it treats markets populated by thinking human beings as if they operated according to the natural laws that govern atoms and molecules. Economists say Soros badly exaggerates the limitations of standard theory and ignores subsequent refinements. But if conventional economics teaches that markets are always (eventually) right, Soros insists they are always wrong.

When reflexivity comes into play, markets go into what Soros calls "dynamic disequilibrium." That means virtuous upside cycles that lead to bubbles and booms, and vicious downside cycles that lead to crises and crashes. Whether Soros is theoretically right or wrong on this issue, he certainly has the market credentials and proven track record to effectively maintain that his theory of reflexivity is practically relevant in the marketplace — at least for him. Soros has popularized the concepts of dynamic disequilibrium, static disequilibrium, and near-equilibrium conditions. Reflexivity is based in three main ideas:
  1. Reflexivity is best observed under special conditions where investor bias grows and spreads throughout the investment arena. Examples of factors that may give rise to this bias include (a) equity leveraging or (b) the trend-following habits of speculators.
  2. Reflexivity appears intermittently since it is most likely to be revealed under certain conditions; i.e., the equilibrium process's character is best considered in terms of probabilities.
  3. Investors' observation of and participation in the capital markets may at times influence valuations AND fundamental conditions or outcomes.
Basically, this means markets are at an equilibrium…until they aren't. And then speculation takes over and brings things to a feverish pitch that can't be stopped by rational theories of economics, throwing out the efficient market theory at this time. When Soros was betting on the pound's decline he was betting that a tipping point had been reached that had made the idea of a pound's decline irresistible to the general public, to speculators, to policy makers, etc and that nothing anybody could do could prevent it, no matter how irrational it might be. It’s when he smells out this type of weakness or strength that Soros will make his biggest bets.
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How he "smells out weakness" though goes one step beyond philosophy and into his own talent. As his own son, Jonathan Soros put it, "when my father's back hurt he knew he was in a bad trade."

The basic lesson for trading success is to understand the big picture. Reflexivity gives us critical insight into the path of the big moves, and that can give you more confidence in your trades. Paul Tudor Jones brought this point home in his foreword to The Alchemy, “How many times,” Jones asked, “have we been correctly long near the bottom or short near the top of a major market move? But our staying power with these positions has been weak (as well as our returns) because of a lack of understanding of the path of big price moves.”

Soros is a macro-investor. This, in and of itself, gives him an edge. Most market participants have neither the resources nor the expertise across many product lines, industries or markets that Soros has. However, you don’t have to be a macro-investor or a fundamentally orientated trader to use reflexivity to improve your trading. For that, you need not only to watch the market, but also the thinking of market participants who are doing something to the market. You can gain an edge if you can identify the major players that are moving prices now (in the markets you trade), and if you can learn that on which they are basing their decisions. Look for situations where everybody is doing the same thing for the same reason.

Then, look for the flaw in this reasoning.  It would be wonderful if there were some hard and fast rule for determining situations in which everyone indeed was doing the same thing for the same reason, but there really isn’t. You have to be intimate with the market, and then you can sometimes tell by both looking at price and volume data as well as at the news where the liquidity is emanating.

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