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George Soros, Reflexivity, And His Success

by: Mike Gorlon
Mike Gorlon
Value, growth at reasonable price, long-term horizon, long/short equity
Summary

George Soros is a philanthropist, author, investor, and hedge fund manager who averaged returns of 31% for more than 30 years.

He wrote the book, The Alchemy of Finance, to communicate his theories on the markets and why he had so much success.

This article summarizes his thoughts from his book that led to his success.

It also summarizes his theories, including his popular but complicated theory of reflexivity.

George Soros is a philanthropist, author, investor, and hedge fund manager of the very widely known Quantum Fund. He is arguably the best speculator of all time and is very well known for his bets against currencies. The Quantum Fund had an incredible return of 31% on average for more than 30 years.

His most famous bet was when he and his fund manager at the time, Stanley Druckenmiller, shorted over $10 billion of the British pound and made $1 billion in that one trade alone. If there is one thing that Stanley Druckenmiller says George taught him, it was that when you see something, bet big.

And coming into work for George at the Quantum Fund one morning, Stanley felt like he found something big after reading in that morning’s Financial Times an editorial by Helmut Schlesigner, Head of the Bundesbank at the time, that Stanley interpreted as basically saying that Helmut didn’t want his country’s currency, the Deutche Mark, to be linked to the British pound anymore.

Here is a first-person account of a brief conversation between Stanley Druckenmiller and George Soros right before they added immensely to their short position:

“’George, I’m going to short $5.5 billion worth of British pounds tonight and buy deutsche marks. Here’s why I’m doing it, that means we’ll have 100 percent of the fund in this one trade.’ And as I’m talking, [George Soros] starts wincing like what is wrong with this kid, and I think he’s about to blow away my thesis and he says, ‘That is the most ridiculous use of money management I ever heard. What you described is an incredible one-way bet. We should have 200% of our net worth in this trade, not 100%.’”

And that is part of the reason why George Soros was so successful. He was willing to bet really big when he found something that he felt he was confident in and he got it right when it counted. And if a trade was about to go in the wrong direction George did have his own ways (some questionable) of being able to identify in advance his errors and why that may lead to his position moving against him. Of course, he wasn’t always correct in identifying the trends but he was much better at it than most.

George Soros wrote the book The Alchemy of Finance and it acts as somewhat of an autobiography to his investing days, an experiment from his investing days when he was running the Quantum Fund, and his theories about markets – including his theory of reflexivity.

George states in the new preface of the 2003 edition of his book The Alchemy of Finance that his goal is very ambitious, “I seek to lay the groundwork for a new paradigm that is applicable not only to financial markets but to all social phenomena.” In addition, he is attempting to convey and even clarify in certain circumstances his theories of the markets and reflexivity. He also adds a lot of the secrets that are responsible for his success. It’s a little bit of a challenging and longer read, but well worth the time and effort. Not only do I believe so, but so does Paul Volcker and Paul Tudor Jones.

“On almost every page, you will suddenly be rewarded by a paragraph, a sentence, or a phrase that will provide fresh insight and challenge your thinking.” – Paul Volker

Despite George Soros’s main theory - his theory of reflexivity - being a bit complicated, I will try and simplify it here with some help from a couple of passages from his book.

To analyze Soros’s theories on markets and what made him so successful, let’s start by first defining what his main theory is using Investopedia:

Reflexivity is the theory that a two-way feedback loop exists in which investors' perceptions affect that environment, which in turn changes investor perceptions.

Human thoughts and emotions are what drive security prices. Since security prices are influenced by human feelings and opinions, markets are subjective rather than objective. A tree is objective and is a part of physical reality. We can see it, touch it, and we know a tree when we see one. But you can’t physically touch a stock price and the price of a security is based on what one is willing to pay for it and what one is willing to sell it for which is based on the thoughts and perceptions of the buyers and sellers. These thoughts and perceptions are subjective because they are inside our minds. In other words, they are abstract.

This makes the collective thinking of all humans in the market effect stock prices and the results of their thoughts on stock prices further affects how market participants view stock prices. Their perceptions of reality, not reality itself, affect stock prices and then this perception gets priced into markets and these perceptions end up affecting the fundamentals of the underlying companies.

Here is a definition from George himself in his book:

“The concept of reflexivity is very simple. In situations that have thinking participants, there is a two-way interaction between the participants’ thinking and the situation in which they participate. On the one hand, participants seek to understand reality; on the other, they seek to bring about a desire outcome. The two functions work in opposite directions: in the cognitive function reality is the given; in the participating function, the participants’ understanding is the constant. The two functions can interfere with each other by rendering what is supposed to be given, contingent. I call the interference between the two functions ‘reflexivity.’ I envision reflexivity as a feedback loop between the participants’ understanding and the situation in which they participate.”

In order to get a better idea lets think about the two ideas below and how each participants behavior influences the other.

Thinking about this in a hypothetical way - based on an idea from one of Howard Marks’ investment memos titled Yet Again - imagine if the game of golf was played a little differently. As the game is played today, the performance of the golfers shooting before you have no effect on the dynamics of the course so they don’t affect your shot other than maybe adding a little bit of pressure if it is crunch time. But imagine if the golfers before you hit really good shots onto the green and these really good shots changed the dynamics of the course.

Good shots now made your shot more difficult or worse shots from the golfers hitting before you made your shot easier. This would make the game of golf much more similar to how markets work because the efforts of investors to succeed and invest well in the market before you can make it harder for others to enter the market and do well. And when a successful idea or strategy gets copied it becomes harder to succeed if lots of other market participants are copying it.

Here is a quote from Charlie Munger at the Daily Journal Annual Shareholder Meeting this month that demonstrates this point:

“When Berkshire came up, we had an easier world than you people are facing this point forward, and I don’t think you’re going to get the kind of results we got by just doing what we did.”

The result of so many smart investors starting up funds has made it harder for new funds. There are less opportunities now because more smart people are looking for them.

It’s why so many recommend being a contrarian to succeed in the stock market also. When the initial group of people buy into an asset at a lower price, the demand pushes up the price which lowers the prospective returns for new investors. And this doesn’t have to be based on assets with correct fundamentals. Speculation can allow this process to work for assets with no fundamentals also, like tulips in the 1630’s. It is based on the thinking participants' perception and the feedback loop that results from that thinking.

I believe a lot of Soros’s success, besides his incredibly high IQ, came from his contrarian theories about how markets work. He didn’t believe in the efficient market theory and he is a very big critic of it. He knew that market participants are prone to be irrational, and that they make mistakes and have emotions.

While investing or trading in the markets, George starts from a position that every human endeavor is flawed and he also claims that market participants are always biased in one way or another. To outperform the market, it helps investors to try and recognize what the flaws of the other players in the market are in advanced. Michael Burry recognizing that the consensus’s view of housing prices always going up and that combining poor quality mortgages with good quality mortgages doesn’t make that group of mortgages deserve the best credit rating available as being flawed in advanced is a good example.

“The major insight I gained from the theory of reflexivity and what I now call the human uncertainty principle is that all human constructs (concepts, business plans or institutional arrangements) are flawed. The flaws may be revealed only after the construct has come into existence. That is the key to understanding reflexive processes. Recognizing the flaws that are likely to appear when a hypothesis is becoming a reality puts you ahead of the game.”

And these flaws just don’t apply to investors. They also apply to the regulators who are market participants themselves and are just as human as all of the other participants. Bigger issues may even arise when the central banks make mistakes because their policies affect markets the most and in addition they seem to forget how fallible they actually are.

“In the absence of equilibrium, it is the task of the authorities to prevent or correct market excesses. But they, too, are fallible. Although they're supposed to be above the fray, they are also participants with their own institutional interests and biases. The result is a reflexive interaction between regulators and markets, a kind of cat-and-mouse game, which occasionally deteriorates into a boom/bust sequence due to the regulators failure to prevent it from happening.”

There are a lot of views of the market that state that stock prices tend to approach an equilibrium but George Soros, as you see from the next couple of sentences, has a totally different view of equilibrium and market prices.

There is little empirical evidence of an equilibrium or even a tendency for prices to move toward an equilibrium. The concept of equilibrium seems irrelevant at best and misleading at worst. The evidence shows persistent fluctuations, whatever length of time is chosen as the period of observation. Admittedly, the underlying conditions that are supposed to be reflected in stock prices are also constantly changing, but it's difficult to establish any firm relationship between changes in stock prices and changes in the underlying conditions.

George concludes that his theory of reflexivity is best to be used along with fundamental analysis, rather than on its own. Fundamental analysis is used to try and find the underlying value of a security based on economic, financial, and other qualitative and quantitative factors but if you only use this method then you would have been shocked to see internet stocks approach levels of over 100 times earnings during the NASDAQ bubble in 2000. These times when stocks become irrationally exuberant or trade in contrast to what the fundamentals are saying cannot be understood by only looking at the fundamentals themselves, but must be understood best by using Soros’s theory of reflexivity also.

“A reflexive model cannot take the place of fundamental analysis: all it can do is provide an ingredient that is missing from it. In principle, the two approaches could be reconciled. Fundamental analysis seeks to establish how underlying values are reflected in stock prices, whereas the theory of reflexivity shows how stock prices can influence underlying values.”

Despite his success, George never found being a hedge fund manager easy. He constantly second guessed himself. One reason for this was because he wasn’t investing for the long term. He was investing for the short term and as we know from Benjamin Graham, “In the short run, the market is a voting machine but in the long run, it is a weighing machine.” He had to constantly be on top of his bets and keep up with the news surrounding each bet on each day just in case something changed drastically.

Here is what George wrote in the journal that he kept back on October 1, 1986 when he thought that he could take a month away from being active with his portfolio:

"I believe my portfolio is reasonably well balanced. If so, I am prepared to sit out a rally in stocks and bonds, especially as I am going to China for a month.

And then what he wrote on October 22, 1986:

“I cut my trip to China short because I was worried about the Japanese portion of the portfolio. I am now on my way back to New York after spending a day in Tokyo.”

“I've been an active participant in one of the classic boom / bust sequences in history and I failed to get out in time. I am now badly caught. It is clear that I ought to get out of the market, but how and when? I don't know what to do because my knowledge of the Japanese market is extremely limited. I expect to pay a heavy price for my ignorance. I find it somewhat embarrassing to get caught in the "bust of our lifetime" while writing about the "boom of our lifetime." Yet that is what has happened. I believe the collapse of the Japanese stock market will prove to be one of the landmarks of contemporary financial history.”

He couldn’t even go a whole month without worrying. And he was right about the Japanese stock market being one of the landmarks of contemporary history. At the peak of the Japanese real estate bubble, the land under the Imperial palace was worth more than the state of California. That's an incredible stat that summarizes how overvalued Japanese real estate got.

The temptations to be in the hottest trend of the day are high when your time horizon is short and you are looking to make big returns. If technology stocks are the hottest trend like they were during the NASDAQ bubble, and the market index that you compare your returns with has these technology stocks in them, then you are highly likely to under perform unless you go long technology stocks despite their high valuations.

What Soros acknowledges later, to his surprise, was that the irrational exuberance in the Japanese real estate and stock markets went on for another three years after he wrote those lines.

Another difficulty he had with being a hedge fund manager was how he identified with his portfolio.

“I soon discovered that running a hedge fund was a deadly serious game: once you identify with your portfolio, your survival is at stake. That is what makes financial markets such a good laboratory for testing your ideas: failing a test can be very painful; passing your test brings relief. The objective evidence is reinforced by emotions. Short on knowledge, I relied heavily on the pain mechanism.”

George was very curious about markets and really enjoyed testing his ideas to try and figure out how they worked.

“’Ever since I became conscious of my existence I have had a passionate interest in understanding it, and I regarded my own understanding as the central problem that needed to be understood.’ I developed a theoretical framework based on the concept of reflexivity to explain the relationship between thinking and reality, and I used the financial markets as a laboratory to test my theory. It is in that sense that this book constitutes my life’s work. I hope that this summing up will bring it to fruition.”

I believe his curiosity and thirst to understand markets so much is what made him less afraid of failure than so many other people and it helped him bet big. Circling back to when Stanley Druckenmiller was a portfolio manager for the Quantum fund, there was another interesting passage about George’s courage to take risks from Stanley’s Lost Tree Club speech that I mentioned before:

“When I took over Quantum, I was running Quantum and Duquesne. [George Soros] was running his personal account, which was about the size of an institution back then, by the way, and he was focusing 90 percent of his time on philanthropy and not really working day to day. In fact a lot of the time he wasn’t even around. And I’d say 90% of the ideas he were [sic] using came from me, and it was very insightful and I’m a competitive person, frankly embarrassing, that in his personal account working about 10 percent of the time he continued to beat Duquesne and Quantum while I was managing the money. And again it’s because he was taking my ideas and he just had more guts. He was betting more money with my ideas than I was.”

And George relied not only on cognitive factors when investing but on body signals as well. Body signals as well as cognition can be a great predictor that something isn’t right based on how we are feeling during a given moment. Sometimes I’ve found from my own personal experience that my body is signaling some discomfort before my mind even realizes it. It is only after a period of time that my mind finally realizes what is going on.

A very simple example when this happens to me is when the room I am working in gets too hot all of a sudden and then my work productivity starts to drop fast. My body gets a very restless feeling and it becomes uncomfortable for me. Then after a couple of minutes my mind starts to realize that it is really hot and I need to turn on the AC or open a window.

Here is George Soros on one of his own indicators that something isn’t right based on his body signals:

“My son is right about the backache. I used to treat it as a warning sign that something was wrong in the portfolio. It used to occur before I knew what was wrong, often even before the fund began to decline in value. That is what made it so viable as a signal... I knew that I did not act on the basis of knowledge; I was acutely aware of uncertainty and I was always on the lookout for mistakes. As I mentioned earlier, it is when I did not know the flaws of my positions that I had to worry. When I finally discovered what was wrong my backache usually went away.”

Managing money is hard enough as it is and Soros was managing billions of dollars which made it even harder. There is one last piece of advice I have from his book that George says helped him a lot. It’s not only been recommended by Soros, but many other successful investors like Ray Dalio have mentioned it also. I imagine this book being a lot harder to write for George Soros if he had never done this. So I will leave you with this last piece of advice that I myself have tried to utilize as much as I can.

“I was greatly helped by the discipline of having to write down my thoughts. My arguments may not strike the reader as particularly well organized, but they are certainly more consistent than they would have been if I had not taking the trouble to formulate them in writing.”

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.