What is George Soros’ Theory of Reflexivity?

Classical economic thinking is based on the principle that markets tend towards equilibrium. This situation is defined as the point at which supply and demand are balanced, and in the absence of external influences, prices typically remain unchanged. In economics terminology, the market clearing price has been achieved.

Economic theory assumes that market participants act on the basis of perfect knowledge, or at the very least act based on rational expectations. This means that even though not all participants are equally as informed, there is one single optimum, ‘rational’ view of the future, and eventually all participants in the market will converge on this view.

This deterministic way of thinking enables many of the same methods employed in the study of physics to be applied in the field of social sciences like economics. This is where impenetrable algebra and complex modelling are used in the pursuit of certainty (or at least to give the impression of it).

There is one key difference though. Unlike physics, economics includes the presence of subjects that have the ability to think. This means that we do not play a passive role in understanding a market, we also play an active role as well since our perceptions and our actions also influence the market in which we are trying to understand.

This introduces an additional element of uncertainty since there is likely to always be a divergence between what participants think, and the actual facts. Yet that thinking also has a role in shaping the facts. Here is how Soros outlines reflexivity in the markets:

I believe that market prices are always wrong in the sense that they present a biased view of the future. But distortion works in both directions: not only do market participants operate with a bias, but their bias can also influence the course of events. This may create the impression that markets anticipate future developments correctly , but in fact it is not present expectations that correspond to future events but future events that are shaped by present expectations. The participants perceptions are inherently flawed, and there is a two-way connection between flawed perceptions and the actual course of events, which results in a lack of correspondence between the two. I call this two-way connection “reflexivity”.

Fallibility

Soros’ principle of fallibility is that as ‘thinking’ participants in economies and markets, our view of the world is always partial and distorted. According to Soros that means our decisions are no longer confined to the facts as we observe them, but our perceptions too:

When events have thinking participants, the subject matter is no longer confined to facts but also includes the participants perceptions. The chain of causation does not lead directly from fact to fact but from fact to perception and from perception to fact. This would not create any insuperable difficulties if there were some kind of correspondence or equivalence between facts and perceptions. Unfortunately, that is impossible because the participants perceptions do not relate to facts, but to a situation that is contingent on their own perceptions and therefore cannot be treated as a fact.

The complexity of the world in which we live exceeds our ability to comprehend it. Rather than being able to link cause and effect we resort to mental shortcuts – generalisations, metaphors and rules-of-thumb. Soros argues that since we as participants are part of the situation we are trying to understand, these mental shortcuts take on a life of their own and further complicate the situation. In an interviewed detailed in the book Soros on Soros, he sums it up in one sentence:

I believe in my own fallibility.

As Soros outlines, our own fallibility (our misconceptions and misunderstandings) provide the foundations for the decisions that in turn shape the events in which we participate. What this means is that all mental constructs are flawed, and so even if there is a kernel of truth it will at times be exaggerated to the point at which it can distort reality.

Soros’ edge is built on appreciating that markets are never in equilibrium and that the divergences are inherent in our imperfect understanding, our own fallibility.

The cognitive and manipulative function of thinking

Our thinking is there to help us make sense of the world around us – described by Soros as the cognitive function of thinking. But our perception of reality is there to help us shape our response, i.e. how each of us wishes to manipulate the world to one that benefits us. Soros calls this the manipulative function. When both functions operate at the same time they can interfere with each other since there is no genuinely independent reality from which to anchor your thinking on:

By depriving each function of the independent variable that would be needed to determine the value of the dependent variable. Because, when the independent variable of one function is the dependent variable of the other, neither function has a genuinely independent variable. This means that the cognitive function can’t produce enough knowledge to serve as the basis of the participants’ decisions. Similarly, the manipulative function can have an effect on the outcome, but can’t determine it. In other words, the outcome is liable to diverge from the participants’ intentions. There is bound to be some slippage between intentions and actions and further slippage between actions and outcomes. As a result, there is an element of uncertainty both in our understanding of reality and in the actual course of events.

Feedback loops

The common way for people to think about actions, behaviour and outcomes is by expressing them through feedback loops. The course of events influences the participants behaviour, which in turn influences the views of the participants, that then play some part in determining how events unfold further, and so on, and so on.

But the feedback loop doesn’t have to look like this, it can be one individual updating his view of the world through his own introspection. To understand that we need to distinguish between the objective and subjective aspects of reality. Importantly there can only be reflexivity when reality includes a subjective aspect. According to Soros:

Thinking constitutes the subjective aspect, events the objective aspect. In other words, the subjective aspect covers what takes place in the minds of the participants, the objective aspect denotes what takes place in external reality. There is only one external reality but many different subjective views. Reflexivity can then connect any two or more aspects of reality, setting up two-way feedback loops between them.

Feedback loops can either be positive (reinforcing), or negative (correcting). While the latter is the central principle of classical economics – that markets tend towards equilibrium – the former involves the views of participants diverging further and further away from objective reality. Until it reaches a point where it collapses in on itself:

It cannot go on forever because eventually the participants’ views would become so far removed from objective reality that the participants would have to recognize them as unrealistic. Nor can the iterative process occur without any change in the actual state of affairs, because it is in the nature of positive feedback that it reinforces whatever tendency prevails in the real world. Instead of equilibrium, we are faced with a dynamic disequilibrium or what may be described as far-from-equilibrium conditions. Usually in far-from-equilibrium situations the divergence between perceptions and reality leads to a climax which sets in motion a positive feedback process in the opposite direction.

The underlying trend

In order to show how this might be reflected in financial markets, Soros introduces an underlying trend, “that influences the movement of stock prices whether it is recognised by investors or not…The trend in stock prices can then be envisioned as a composite of the “underlying trend” and the “prevailing bias”.”

The price of the asset is determined by two factors, the underlying trend and prevailing bias, both of which are, in turn, also influenced by asset prices. As Soros outlines, the interplay between asset prices, the underlying trend and the prevailing bias has no constant.

“Typically, a self-reinforcing process undergoes orderly corrections in the early stages, and if it survives them, the bias tends to be reinforced, and is less easily shaken. When the process is advanced, corrections become scarcer and the danger of a climatic reversal greater.”

The challenge for every investor is to understand where reflexivity works to their advantage, and when it starts to work against them. This quote perhaps best exemplifies Soros’ theory of reflexivity as it pertains to financial markets:

“Economic history is a never-ending series of episodes based on falsehoods and lies, not truths. It represents the path to big money. The object is to recognize the trend whose premise is false, ride that trend, and step off before it is discredited.”

The paradox

The upshot of Soros’ work is that in order to have stability you need fundamental values to sustain it, yet his theory of reflexivity undermines the belief in fundamental values.

What happens when the fundamental values are flawed or, even worse, people come to the conclusion that all fundamental values are flawed? The system becomes unstable, it enters into a state of dynamic disequilibrium. The trouble is that, in accordance with my theory of reflexivity, all fundamental beliefs are indeed flawed, as all human constructs are flawed. In certain circumstances, the deficiency is liable to become apparent and, if my theory of reflexivity becomes generally accepted, the potential deficiency of all fundamental values become apparent.

How then to take a position (hold a belief) in situations where there are thinking participants, when what is required is to believe in something you know to be flawed?

According to Soros the only way forward is to “accept that our understanding is inherently imperfect,” have “recognition of one’s own fallibility”, and to “show that the ultimate truth is not attainable.”

Further reading

Quotes by Soros in this article have been taken from a variety of sources including Soros on Soros: Staying Ahead of the Curve, The Alchemy of Finance and an article by Soros published in the FT.


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