Theory of Reflexivity - Are we ready

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 35th wealthiest person in the world in 2004, with an estimated net worth of $14.2billion.
Soros is famously known for breaking the Bank of England in 1992 when his bearish trades precipitated the fall of the European monetary system. And as the man who was responsible for a large number of stock market and currency market crashes (including the asian currency crisis) had operated by focusing heavily on the theory of reflexivity. 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 is very interesting and helps investors and speculators in identifying phases of market disequilibrium and helps him/her profit from such phases of market disequilibrium.
The theory of reflexivity acts in sharp contrast to the Efficient Market Theory which states that the market is perfect and the stock prices will discount/factor-in all known and unknown (insider) information.
The theory of reflexivity states that any significant events / developments can disrupt the market equilibrium and the market becomes a victim of irrational exuburence.
When there is a bad news people start selling and hence prices tumble. Looking at the stock prices tumbling, people start selling more because of fear, stock prices fall further and the viscious circle continues.
Similarly, when there is a good news stock prices increase. People become excited, buy more stock and the stock prices rise even further and thus the chain continues.
This is where a rational economic man / value investor would identify the opportunity. Though stock prices might temporarily behave irrationally, research has proved that over the long term, stock prices reflect a company’s performance. Hence it is important that an investor enters the market and takes positions when the market is in disequilibrium and waits patiently for the markets to return to their equilibrium state and then reverse the positions taken. Possible causes of inequilibrium are favourable or unfavourable political development, corporate announcements (bonus, stock split, rights issue, new orders and so on). In such cases stock prices may move irrationally because 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.”

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.