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George Soros’ Theory of Reflexivity is a fascinating economic maxim derived from investor’s perceptions of the economic market place and market values and our forgetting to include what our own impact on the market is.

Soros believes these perceptions control price trends, domestic government regulation and foreign markets.

Guest post by Susan Porter of  Stock Trading Blog.

Hungarian born, a graduate of the London School of Economics, Soros is Chairman of Soros Fund Management LLC. 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. The insights contained in the book and gleaned throughout Soros long career led to Soros’ “billion dollar day” when he made over a billion dollars shorting the British Pounds (GBP) and buying German Marks (DM) earning him the reputation as “The Man Who Broke the Bank of England”.

Each of Soros’ achievements are tied to his own concept of reflexivity which asserts that prices are not set objectively, rather they’re based on the public’s perceptions or biases of value. He also states that investment trades are usually based on biased behaviors or perceptions. And he states that various movements in the financial market created by these biased perceptions and trades can actually change the underlying principles and real value of the economic market. In other words, Soros states that there is a symbiotic relationship between the fundamental underpinning of the marketplace, the market’s pricing, and the participants in the markets, who make trades based upon biased perceptions.

Soros’ reflexivity theory also states that traditional economic principles often attempt to avoid subjectivity and biased perceptive issues. Conventionally, many economic theorists state that people behave rationally when they make economic decisions. Of course, this isn’t also ways true, and according to Soros, reflexive, biased behavior is visible throughout all economic markets. He points to self-reinforcing price based stock performances, such as individual people buying when they see a stock go up, and selling when they see it go down, which in turn create wider economic fluctuations throughout investment and credit markets internationally.

 

The theory of reflexivity basically asserts that individual biases can at least potentially alter basic economic fundamentals. Soros claims that his concept of reflexivity, led directly to his own financial success through his understanding of the results of reflexive effects in the market. He also states that reflexivity is most easily witnessed when investor bias grows and widens through trend-monitoring speculators and situations that employ the leveraging of equity.

 

In the current economic environment, a good example of reflexivity has occurred in the housing market. As lenders made more cash accessible to home buyers, more people bought more expensive housing, which increased the prices of housing. Because the housing prices increased, investments in housing looked sound, and more money was lent. With loans guaranteed by the government, and a general government-sponsored attitude of the positive nature of home ownership, prices and desire for homes both mounted, lending standards were lowered, and the housing market and the lenders investing in it both reacted reflexively to the biased perception that these actions would lead to continued economic gain.

 

Succinctly, Soros’ theory of reflexivity is an exceedingly useful tool for evaluating the reactions of the economic market. It essentially refers to a circular relationship moving between cause and effect, with both affecting each other in a self-referencing economic symbiosis. Reflexivity occurs when the observations and actions of individuals actually affect the situations or markets they are watching. Reflexivity is a methodology that unites the observer and the observed, and one which, according to Soros’ theory, can ultimately provide the insight an investor needs to monitor market trends and make and create successful trading situations.

 

Susan Porter is a financial writer whose interests span from market research, to stock trading, to psychology. Read more of her work on the blog Stock Trading!

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