Learning from George Soros' Books

One trap you can fall into in life is not learning from those that you disagree with, for one reason or another. George Soros would be an example of that. His politics are very different from mine, as well as his religious views. He’s a far more aggressive investor than I am as well. I aim to hit singles with high frequency over the intermediate term. He played themes to hit home runs.

The Alchemy of Finance made a big impression on me 15 years ago. Perhaps it was a book that was in the right place at the right time. It helped to crystallize a number of questions that I had about economics as it is commonly taught in the universities of the U.S.

First, a little about me and economics. I passed my PhD oral exams, but did not receive a PhD, because my dissertation fell apart. Two of my three committee members left, and the one that was left didn’t understand my dissertation. What was worse, I had moral qualms with my dissertation, because I knew it would not get approved.

My dissertation did not prove anything. Most responses would simply point to my work and say, “We’re sorry, but we don’t know anything more as a result of your work here.” I have commented before that the social sciences would be better off if we did publish results that said: Don’t look here, Nothing going on here. But that's not the case. So many grad students in a similar situation choose to falsify their data and publish. I couldn’t do that. I also couldn’t restart, because I had put off the wedding long enough, so for my wife’s sake, I punted, and became an actuary.

That said, I was a skeptical graduate student, and not very happy with much of the common theories. I wondered whether cultural influences played a larger role in many of the matters that we studied. I thought that people satisfied rather than maximized, because maximization takes work, and work is a bad.

I saw how macroeconomics had a pretty poor track record in explaining the past, much less the present or future. In development economics, the countries that ignored the foreign experts tended to do the best. Even in finance, which I thought was a little more rigorous, I saw unprovable monstrosities like the CAPM and its cousins, concepts of risk that existed only to make risk uniform, so professors could publish, and option pricing models that relied on lognormal price movement.

Beyond that there was the sterility of economic models that never got contaminated by data. I was a practical guy; I did not want to spend my days defending ideas that didn’t work in the real world. And, I felt from my studies of philosophy that economists were among the unexamined on methodology issues. They would just use techniques and turn the crank, not asking whether the method, together with data collection issues made sense or not. The one place where I felt that was not true was in econometrics, when we dealt with data integrity and model identification issues.

Wait. This is supposed to be a book review. Um, after getting my Fellowship in the Society of Actuaries, I was still looking for unifying ideas to aid me in understanding economics and finance. I had already read a lot on value investing, but I needed something more.

On a vacation to visit my in-laws, I ended up reading The Alchemy of Finance. A number of things started to click with me, which got confirmed when I read Soros on Soros, and later, when I began to bump into the work of the Santa Fe Institute.

I was already familiar with nonlinear dynamics from a brief meeting with a visiting professor back in my grad student days, so when I ran into Soros’ concept of reflexivity, I said “Of course.” You had to give up the concept of rationality of financial actors in the classical sense, and replace them with actors that are limitedly rational, and are prone to fear and greed. Now, that’s closer to the world that I live in!

Reflexivity, as I see it, is that many financial phenomena become temporarily self-reinforcing. We saw that in the housing bubble. So long as housing prices kept rising, speculators (and people who did not know that they were speculators) showed up to buy homes. That persisted until the effective cashflow yield of owning a home was less than the financing costs, even with the funky financing methods used.

Now we are in a temporarily self-reinforcing cycle down. Where will it end? When people with excess equity capital look at housing and say that they can tuck it away for a rainy day with little borrowing. The cash on cash yields will be compelling. We’re not there yet.

Along with that, a whole cast of characters get greedy and then fearful, with the timing closely correlated. Regulators, appraisers, investment bankers, loan underwriters, etc., all were subject to the boom-bust cycle.

Expectations are the key here. We have to measure the expectations of all parties, and ask how that affects the system as a whole.

In The Alchemy of Finance, Soros goes through how reflexivity applied to the Lesser Developed Country lending, currency trading, equities, including the crash in 1987, and credit cycles generally. He gives a detailed description of how his theories worked in 1985-6. He also gives you some of his political theorizing, but that’s just a small price to pay for the overall wisdom there.

Now, Soros on Soros is a series of edited interviews. The advantage is that the interviewers structure the questioning, and forces more clarity than in The Alchemy of Finance. The drawback (or benefit) is that the book is more basic, and ventures off into non-economic areas even more than The Alchemy of Finance. That said, he shows some prescience on derivatives (though it took a long time to get to the promised troubles), though he missed on the possibility of European disintegration.

On the whole, Soros on Soros is the simpler read, and it reveals more of the man; The Alchemy of Finance is a little harder, but focuses more on the rationality within boom/bust cycles, and how one can profit from them.

Full disclosure: if you buy through any of the links here I get a small commission.

Comments

[ICouldBeWrong]

I consider The Alchemy of Finance to be a masterpiece (Soros on Soros is great too). It provides a detailed description of the global financial system, and how it really works. The real time experiment was an inspiration for my personal trading regime. The theory of reflexivity explains how bull and bear markets develop. But best of all is the philosophical underpinning of the entire work, Soros admits he is fallible and could be wrong.

I do have one criticism of The Alchemy of Finance, the book is very dry and is not very enjoyable to read. If I recall correctly Soros does not make a single joke in the entire book. (Soros on Soros is a bit better but still little or no humor).

I also have one caveat, The Alchemy of Finance is not for beginners. It's an advanced work.

[ikkyu]

Greetings,

I too would say that the Alchemy of Finance is an excellent work as well. I have considered the "theory of reflexivity" outside of finance, too. You can really see this as a philosophical school in finance that is based on the philosophy of Karl Popper and is represented by the ideas of Soros and Nassim Nicholas Taleb (of Black Swan fame), though clearly the former is more interventionist and the latter more libertarian.

Nice review.

Cheers from Osaka,
john

[BxCap]

I've read three of Soros' works and a speech he gave on the Theory of Reflexivity, and he does use quite a few words to explain some very simple ideas. His works are worth the time, but if you can find a synopsis, use that instead.

www.geocities.com/ecocorner/intelarea/gs...

[BxCap]

I wanted to add that I always enjoy your pieces David and am glad to hear you say that data is used as if it is not compromised. For instance, the past six years of market data has co-mingled with a trader's market. Where do you draw the line between useful information on how stocks react under certain circumstances, when you have option trading, two new Dow 30 components, credit default swaps influencing bonds, hedge fund implosions, government intervention on multiple levels, and numerous financial packages that appear and disappear (CDO, ABS, MBS, CDS, etc.). And yet, economists and financial pundits treat charts, graphs and pools of data as if they are something upon which you can formulate a law, theory, postulate, or observation. I'm glad you brought up that aspect of your past, as again, something we can all learn from.

[L Moore]

Two thoughts. First, Soros continues his ideas in his The Age of Fallibility (2006) although he takes aim at society at large. He does anticipate the mortgage/credit crisis and suggests outcomes. He argues that we are all a 'feel good' society and that we don't seem to have the same commitment to world well being as was held in the 1950s-1960s.

Secondly, of course well are a feel good society. The great awakening of the 1960s and 1970 transformed America from a rationalist-led soceity into one led by Romanticism, from left brain thought and behaviour to right brain thought and behaviour. The Second Enlightenment (circa 1905-1985) is over and another Gilded Age is upon us. Our society is now behaving intuitively, nonlinear, cyclical, fractal, nonsystematic, and creatively. In other words, "irrational". Understand romanticism not as an artistic movement but as a full blown cultural one and you better understand our current economic, financial, and political crisis.

[Milind]

I admire George Soros for specific reasons. His knowledge of economics seems worthy of an LSE graduate.

However, I was disappointed with his "theory of reflexivity." All he seemed to do was observe and, perhaps, try to explain the boom-bust phenomenon, which is already well known and well documented in biological systems as well as financial markets. Remember the "predator-prey relationship" from grade school? Not sure what Soros added to our understanding of this phenomenon.

I do agree wholeheartedly that it seems realistic and useful to model financial markets as complex adaptive systems. The work of the Santa Fe Institute and other research in non-linear dynamics should revolutionize the science of economics. This work should replace outdated theories that, for the sake of mere expediency or mathematical curiosity, assume rationality and perfect information with models that are realistic and have predictive value. Furthermore, the self-similarity explained by non-linear dynamics should help unify microeconomic and macroeconomic theories.

[The Rock]

Hi, I am from Malaysia and I've read the Alchemy of Finance more than 1 year ago. I have to read it at least 3X before I can really grasp the concept of reflexivity. I wished they teach that in the CFA syllabus. It blends behavioural finance into the boom/busy cycle. We are all humans - the participants of economy and markets.

Supposed the market can reach an extreme point of pessisism before it will recover. Then again Soros mentioned that the government of the day will react. Fed etc are doing whatever they can think of to mitigate the credit crunch. While we can't forecast the bottom, the comfort that we have today is that the central banks are acting without hesitating.

[bluesmoke]

David, always enjoy your posts and appreciate your honesty. There are many people like Soros. many of whom I have admired from a distance. But I try not to overthink all this stuff. After reading and researching as much as I can, I use collective judgement. Your "base hit" philosophy makes the most sense to me.

[Alpha Seeker]

This is the worst article because just the fact that the the author gets a small commission for any of the books sold though the links, makes him give a biased opinion. Soros is just an insider-edged trader, really not that good in economics, and his luck played a very good role in his success.I doubt the author can put two and two by reading his dry books. In addition, anyone that goes for Phd in economics, is looking to find the secret to "the model that will make me money" in the wrong place. Academia will not teach you or show you jack.

[Ames Tiedeman]

Soros also needs to be seen as nothing more than an opportunist. This is a man who shelled out trade policy advice to people like the Clinton's. Our trade balance has reached a catastrophic 800 billion and our currency is now the peso of the Western World. People wonder what went wrong with America. All the talk and no real answers. The majority of our economic problems can be found buried in the Trade Deficit. It is obscene that we are closing auto plants and China is opening them to sell us cars. Wake up!

[steveballmer]

Sorry people but Soros is a communist idiot! How he got so rich is something I will never figure out, but that does not change the truth!

fakesteveballmer.blogspot.com

[JasonT]

Two words: Harry Dent .. the only real market forecaster worth listening too.

[vrspace]

If you missed it - here is the uncut version of the Soros interview on CNBC Weds April 2/08 (windows media player - cut and paste link in your browsers address bar)

plus.cnbc.com/results/videoPlaylist.jsp?... @cnbc.com%26key%3DORYfrylJRKq1GAAaqPabb%...