Theory of Reflexivity – Understanding George Soros’ Theory
Table of Contents
What is Reflexivity in Trading? A Definition
What does reflexivity mean in trading? To understand how reflexivity works in trading and economics, we first need to understand its meaning in sociology, where the term originated.
|In sociology, reflexivity means an act that bends back to, or affects, the entity that originally engaged in the action.|
So, what is the theory of reflexivity in economics? One of the first people to apply the theory of reflexivity to economics was world-famous investor George Soros.
Here is a reflexivity definition in terms of economics:
|The theory of reflexivity in economics is a theory stating that a self-fulfilling cycle exists in which traders’ perceptions influence the fundamentals of economic activity, which in turn influences traders’ perceptions.|
George Soros not only applies his general theory of reflexivity to economics but argues that it can significantly shift our understanding of economics under modern economic models.
This can also affect how traders perceive market movements.
So, what do we do with the generally accepted economic theories we’ve established over the centuries that George Soros’ theory of reflexivity challenges?
We'll come back to that later.
For now, we’ll answer the question, “what is the theory of reflexivity?” and discuss what it implies for modern economic models.
Understanding Soros’ Theory of Reflexivity
George Soros’ reflexivity theory states that investors don't base their decisions on reality, but rather on their perceptions of reality.
The actions resulting from these perceptions impact reality, or fundamentals, which then affect investors' perceptions and, thus, prices.
The process is self-reinforcing and tends toward disequilibrium, causing prices to become increasingly detached from reality.
George Soros’ reflexivity views the 2008 global financial crisis as a key example that illustrates this process.
In this view, rising home prices induced banks to increase their home mortgage lending which itself helped drive up home prices.
Without a check on rising prices, a price bubble formed, which eventually collapsed and caused the financial crisis and Great Recession.
In short, the natural reflexivity of the financial system was one cause of the crisis.
Now that we have a fundamental definition of reflexivity, it’s time to expand our understanding of the theory of reflexivity, and examine what reflexivity is not.
What the Theory of Reflexivity is Not
The theory of reflexivity can overwhelm some people when they first discover it.
Can George Soros’ theory of reflexivity really disprove all generally accepted economic theory?
Is the theory of reflexivity really so profound?
While we can’t answer these questions today, we can answer another important question, “What is the meaning of the theory of reflexivity in economics?”, and clarify aspects of it.
Theory of Reflexivity vs Mainstream Economic Theory
According to the definition of reflexivity in economics, modern mainstream economic thought doesn’t account for certain unpredictable aspects that influence the markets. Soros’ reflexivity does.
Mainstream Economic Theory
Soros’s general theory of reflexivity refutes the following traditional economic concepts:
- Economic equilibrium
- Rational expectations
- Efficient market hypothesis
Let’s look at each of these in detail and how they contrast the theory of reflexivity in economics.
In traditional economic theory, these fundamentals that drive supply and demand ultimately establish price equilibrium.
However, there are two core economic fundamentals that the theory of reflexivity and mainstream economics perceive differently:
- Consumer preference
As a result, each theory reaches different conclusions on how price trends behave.
According to mainstream economic theory, as scarcity and consumer preference fluctuate, market participants bid prices higher or lower based on their more or less rational perceptions of these fluctuations.
In other words, according to modern economic models:
|Market participants digest fundamental economic factors, such as what people want and how much of it is available, to bid prices. This positive and negative feedback between prices and what people expect are always moving towards an equilibrium.|
As long as there is open communication of this fundamental information and people continue to engage in transactions at the agreed prices, the market will always be driven towards equilibrium.
George Soros’ theory of reflexivity sees it differently.
George Soros’ Theory of Reflexivity
Soros believes that the general theory of reflexivity reveals that price behaviour doesn’t follow such a price equilibrium model.
Instead, prices often deviate significantly from the price equilibrium.
His main point:
|According to George Soros’ theory of reflexivity, prices are reflexive, driven by positive feedback loops between expectations and prices.|
What exactly does this mean?
When a change in the economic fundamentals occurs, this feedback loop pushes prices beyond the new point of equilibrium. They overshoot it.
In theory, the negative feedback between these factors would normally balance the positive feedback effect, causing the prices to settle at a new point of equilibrium.
However, according to Soros’ reflexivity, these negative feedback loops fail.
Eventually, market participants see the price trend overshooting the point of equilibrium and becoming detached from reality.
They adjust their expectations accordingly, causing the trend to reverse. (Soros doesn’t acknowledge this reversal as negative feedback).
Proof of Soros’ General Theory of Reflexivity
Modern economic thought asserts that markets trend towards equilibrium and that market crashes are caused by external shocks.
However, George Soros’ theory of reflexivity in economics asserts that market crashes are a result of the nature of our current financial system.
There are similar patterns in our markets, in general, that he uses as evidence of reflexivity. These are:
- The boom-bust cycle
- Price bubbles followed by price crashes
In these cases, prices deviate greatly from equilibrium points implied by mainstream economic theories.
What factors might help initiate these processes?
- Availability of credit
- Use of leverage
- Floating currency exchange rates
The results are magnified in times of major market crashes.
As we mentioned above, modern economic thought asserts that market crashes like the financial crisis of 2008 are caused by an external shock.
Soros’ theory of reflexivity argues that the 2008 crisis wasn’t caused by an external shock to the market like the dissolution or formation of an oil cartel.
Instead, it was caused by these and many other factors that are inherent in our current financial system.
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Combining the Theory of Reflexivity With Modern Economics
We now have a fundamental understanding of what the theory of reflexivity is.
Let’s return to the question we proposed at the beginning: what does George Soros’ theory of reflexivity in economics mean for modern economic thought?
Reflexivity is difficult to model using the same methods as modern economic thought.
Therefore, it's challenging to find a reflexivity model we can use to understand and predict market behaviour.
However, Soros believes that we need to include a margin of error to account for the incalculable uncertainties that his theory implies.
How Can Traders Use the Theory of Reflexivity in Trading?
While current models can be useful for calculating risk under the modern economic models, Soros’ reflexivity has shown that conditions can steer very far away from the anticipated equilibrium point.
As such, George Soros’ theory of reflexivity stands in the face of a well-founded body of mainstream economic thought, which some traders find hard to ignore.
They often take his theory into account along with their traditional models when analyzing charts, trends, breakouts, and attempting to predict important price movements.
Some traders believe that taking both perspectives into account is a more sound approach to analysing market behaviour.
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