George Soros and his theory of reflexivity

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'Reflexivity' is not as you might suppose, some offshoot of complementary medicine, but the theory devised by George Soros, the doyen of hedge fund managers, to explain the nature of movements in the market.

For those who - like me - can remember graphically Soros's stagging of the UK gilt market in the late 1970s and his role in the ejection of sterling of the EU exchange rate mechanism in 1992, Soros's ideas are as topical as can be. Recent weakness in sterling is reminiscent of the latter early-1990s episode. So examining his theory right now might be a good idea.

Soros is, of course, one of the best-known figures in the stockmarket. Born in Budapest in 1930 with the Hungarian name Dzjchdzhe Shoras, his father was a lawyer, but had spent some years in Russia in the immediate aftermath of the revolution, and was by all accounts a survivor, unconventional and wily. He was, for example, a writer in the international language Esperanto.

After the post-war Soviet takeover, George Soros left Hungary for Switzerland in 1946, fleeing while attending an Esperanto youth conference. Shortly thereafter, in 1947, he moved to London, surviving by doing odd jobs, later studying at the London School of Economics. Subsequent jobs included selling ladies handbags in Blackpool.

Soros eventually gravitated to the City with a job at merchant bank Singer & Friedlander, becoming a trader specialising in arbitraging gold stocks. He moved to New York in 1957 and continued working as an arbitrageur for the firm of FH Mayer, later moving to Wertheim. There he continued his arbitrage activities, ferreting out discrepancies in value in both US and international stocks. In 1963, Soros moved to A&S Bleichroeder, a leading US firm with a bias towards international markets.

Soros's contrarianism, his global outlook, his background in arbitrage, all suggests a hedge fund trader in the making, particularly one that specialised in so-called macro 'big picture' trades. Some of these lessons were learnt from his father. He taught that it was acceptable to take risks, as long as one did not risk all one's capital doing it, and also that perceptions were often more important than reality.

This brings one to Soros's ideas about how financial markets work.

One of Soros's theories is that, put simply, financial markets do not tend towards equilibrium, as conventional theory would argue. Rather, they feed on their own misconceptions about events to produce exaggerated movements, which produce new misperceptions.

This two-way feedback between perception and reality Soros describes as his theory of 'reflexivity'. It is, he claims, something that the shrewd investor can exploit by following the trend till it reaches the peak, and then, identifying what Soros calls the 'inflection point', switch to the opposite tack. The concept of an inflection point is perhaps not new, but simply a renaming of the concept of a sharp upward or downward spike in the market.

Soros acknowledges in his book The Alchemy of Finance that the theory is an abstract one and not particularly helpful as an aid to trading, not least because the inflection point cannot be recognised as such until after it has occurred. But the theory does, he claims, offer help in analysing and explaining events in the market.

One interesting, although not particularly comforting fact for holders of sterling is that Mr Soros claims that speculative runs on a currency can persist for a long time and relative movements in one currency against another are frequently of a long term secular nature, sometimes measured in years, rather than days or weeks.

Peter says

While Soros has been one of greatest investors of the last 50 years, his attempts to present himself as a philosopher are, to many, not entirely convincing.

Nonetheless, it can't be denied that he has a feel for market opportunities that has been demonstrated time and again, and that his theory of the reflexive nature of markets, especially highly liquid ones like foreign exchange, has considerable plausibility.

Less plausible perhaps were the claims that Soros made in testimony to the US Congress in 1994. He was asked if it were possible for an investor like him to amass enough capital to manipulate the value of a currency. Soros said that: "I do not believe that any market participant can, other than for a very short time, successfully influence currency markets for major currencies contrary to market fundamentals... Hedge funds are relatively small players given the size of global currency markets."

In a sense, however, this is not quite the point. Influencing markets for a short time, given the leverage at their command, is all that hedge funds and proprietary traders need to do to make profits.

Furthermore, the essence of the power of high-profile investors like Soros wield is that other investors follow them, adding to their influence and producing the desired effect. One of the reasons for the reflexive nature of financial markets is the ever present herd mentality that exists within them.