Who is George Soros?

Here stands but a humble attempt at demystifying the enigma that is George Soros’s Theory of Reflexivity. Doing so in a single article is a challenge. My disclaimer: to do true justice to the topic you would have to read the lengthy books, articles, and memo’s devoted to it. There is a lot of material that needs to be covered to truly comprehend and apply the philosophy.

George Soros’s books Soros on Soros – Staying Ahead of the Curve and The Alchemy of Finance come highly recommended.

However, if that all seems a bit too strenuous at the moment, let’s keep it more relaxed and start with the basic premise.

Firstly, who is George Soros? In one sentence – He is considered by some (including me) to be one of the most successful investors in the world. He is a philosopher and hedge fund titan who is famously (notoriously?) known as “The Man Who Broke the Bank of England”.

The Man Who Broke the Bank of England? –  In Britain, the 16 September 1992 became known as Black Wednesday, the day that speculators “broke the pound”. They didn’t actually break it, but they forced the British government to pull it from the European Exchange Rate Mechanism (ERM).

George Soros’s life story is an interesting tale – should you find yourself with the time to dig a little deeper. His legacy is built from the confines of war-stricken Hungary, to the lecture halls of England. He subsequently tackles the bustling streets of New York City where he became the public figure we know today. This article however is supposed to be about his philosophy and not the man himself. I have digressed, lets get back on track.

The Theory of Reflexivity?

George Soros claims one of the reasons he is so successful at investing is due to the application of the philosophy of “reflexivity” developed by Karl Popper. Karl Popper was one of the greatest philosophers of science in the 20th century. George (I can call him George right? Mr Soros feels a bit too formal) developed and extrapolated the philosophical methodology and applied it to financial markets.

Simply the theory is based on two realities namely Objective Realities and Subjective Realities.

Objective Realities

Described in more detail, objective realities cannot be altered by your thoughts or comments. As an example, the weather is an objective reality.

Why?

If you were to look out the window now and see that it is raining. You subsequently turn around and profess to everyone “it is sunny”, besides getting some worried looks, your opinion will not have affected the weather. It will continue to rain.

Subjective Realities

Subjective realities are the exact opposite of this concept.

Sticking with the above example and let’s pretend weather became a subjective reality. This would mean that if you turn around and say “hey it is sunny” (and enough people started saying it) the weather would subsequently turn from rain to sun.

Have you got the distinction between the two realities? Pretty straight forward.

So how does this apply to Financial Markets? Without being too presumptive you are probably aware or have at least come to suspect that Financial Markets are based in a version of the subjective reality.

I.e. the more people who say you should and actually are buying shares, the higher the price goes. Conversely the more naysayers and sellers mean the lower the price sinks.

By applying this knowledge when selecting shares you are able to avoid certain bias’s, note certain trends and avoid hidden bubbles.

How does this work?

Well let’s apply an example. Back in South Africa, on the Johannesburg Stock Exchange (JSE), a share called Naspers accounts for a staggering 15% of the All-Share Index. Forgetting the fundamentals that made this company have such a large market cap, we can do a quick, simple search and depending where you look it has a P/E ratio of over 50. This means the price of the share is 50 times more than what it earns per share. In even more simple terms it means if you pay for one share you will need to wait 50 years to get your money back [et al].

So, the question is how did the price of this share grow exponentially despite its “lower” earnings? Well, this is in part due to the reflexivity of the market. Enough people “believed” in the share, perhaps that it is innovative, or has future profits looming, or that it is eating up market share, or any other positive belief unmentioned.

Whether true or not a consistent belief will drive the price up (or down) – but hold on that is just how the stock market works right? Different opinions are exactly why we are able to close trades and why there is volatility. Well, the point of reflexivity is that this belief/perspective/opinion goes even further and affects the very fundamentals of the company its self.

Why subjective realities affect the fundamentals of a company?

The higher share price and investor confidence means that Naspers finds it easier to receive cheaper financing on its numerous mergers and acquisitions, meaning it can undercut its competitors, it is able to utilize share options to compensate employee’s and avoid large payroll costs, it can attract the best talent and develop the business model that promotes even more growth. It can gain better access to finance and banks, as well as take on more leverage than its competitors. There are numerous benefits that are derived from a strong public perception, more than I can mention in this short paragraph.

The mere belief in the price of a share, which pushes up the share price, affects the fundamentals of the company. As the price grows, perception is improved/justified and there will be more belief. The cycle repeats, and the fundamentals are affected again, and again and again.

You are changing rain into the sun by merely professing it is so!

Does that mean a bubble exists?

Well eventually public perception will need to change or dissipate, otherwise YES! The company will continue to develop within this loop until it “bursts”. This is partly how George Soros managed to correctly short the pound and “break the Bank of England”.

The opposite side of the spectrum is just as likely to occur. A different example to illustrate negative beliefs is described by the deterioration of African Bank (Another JSE Share) in 2015. The bank would eventually get bailed out and begin the process of recovery. The fact is even 2.5 years later the bank was struggling to recover as the market maintained its negative outlook. Despite rectification of its loan policies and reserving and a removal of its bad book it cannot shake the public sentiment. This has resulted in the share price continuing to stagnate and struggle.

What the point?

Our combined belief affects the very fundamentals of a company. This results in long-term discrepancies between reality and what the price of a security actually is. Our perceptions can pull a companies reality towards our own perceptions if enough voices join in.

Some may go as far as to say in order to be a truly successful investor, we are better off predicting human’s behavioural response to information rather than any amount of fundamental analysis.

I believe there is a place for both fundamental and behavioural analysis. They are not mutually exclusive and should be considered in conjunction with each other.

George Soros believes the markets are constantly mispriced due to the forever swinging perception of all the investors which never reaches equilibrium. Sometimes there are excessive differences and sometimes differences that are hardly perceivable. It is our job as an investor to utilize these discrepancies and to subsequently profit.

Is equilibrium real?

In a world where our financial system is based on economic theories centered on a philosophy of equilibrium. I.e. If you studied Economics you learn that a market should always move to meet equilibrium (supposedly). Assuming the theory of reflexivity is true, it seems obvious this move to equilibrium would have failings. Perceptions distort and move reality away from equilibrium. After all, the theory of reflextivity says the market is never in equilibrium.

We live in a world where we expect supply to increase to meet demand, or vice versa. We are taught in universities throughout the world to accept this as as objective truth. Finally we expect everything to “return to normal” but we live with a financial system that is based on subjective truths – our feelings, thoughts and attitude.

People overshoot and undershoot the mark consistently. This pushes anything from political reforms to financial markets off equilibrium. How can we try to apply an economic framework that assumes equilibrium to a market that is consistently in turmoil?

Since we apply an economic model that does not fit reality, I suggest we utilise the theory of reflexivity as best as we can. Use it to help profit and predict the assured future downward/upward swings that will occur in our lifetimes.

Happy investing!

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