Reflexivity in Financial Bubbles An Alternative Theory of How Markets by Link Daniel

soros theory of reflexivity

Consider the reflexivity at work behind the career of Thomas Edison (Figure 3). Observing the success of his inventions, he grows more confident and is encouraged to invent more and repeat the cycle. In its abstract form, reflexivity occurs independently of the truth of the underlying beliefs. In the Pygmalion Effect (Figure 2), whether the student is naturally gifted or not is immaterial; the student improves because of the teacher’s belief and actions. Soros seems more interested, however, in reflexive phenomenon where the underlying belief has questionable truth, or where errors are introduced in the three behavioral functions (either cognitive, manipulative, or sensing). What does this have to do with house prices in Las Vegas or credit availability in Tampa?

  • And whether people believe it is raining or not cannot change the facts.
  • Now, having spent more time in the financial markets, I believe he was correct in his observations.
  • The framework deals with the relationship between thinking and reality, but the participants’ thinking is part of the reality that they have to think about, which makes the relationship circular.
  • Here, I explain how expectations about stock prices and expectations about fundamentals change in relation to one another at turning points in boom-bust cycles when they are the most “out of balance” in order to explain turning points as phase transitions as widespread belief reversals.

When the fallout of the crisis spread from the USA to Europe and around the world it enabled me to explain and predict events better than most others (Soros, 2012). The crisis put in stark relief the failings of orthodox economic theory (Soros, 2010). As people have realized how badly traditional economics has failed, interest in reflexivity has grown.

Boom-bust cycles and the nature of reflexive economic agents

Insiders begin to sell, and speculators realize that prices can no longer rise the way they did in the past. Eventually, the boom will culminate into the panic phase, when investors frantically dump assets. Brunnermeier argues that in the Minsky model margin calls and weakening balance sheets lead prices to spiral down, and if the run-up was financed with credit, amplification and spillover effects, this can also lead to severe overshooting in the downturn.

soros theory of reflexivity

In each of these three examples, improving market sentiment has driven a virtuous cycle. As shares in each company have risen in value, more investors have become involved, which has pushed the stock higher, allowing the company to raise capital, helping to strengthen the balance sheet and attracting more investors. Negative feedback is thus fully consistent with the ordinary cause-and-effect reasoning of Table ​Table2.2.

Why has nobody noticed that a crisis was under way?

The short-term price top is displayed in Calandro’s chart with the small arrow and it is important because it represents the first major test of whether or not the trend of higher prices will be continued or not. If the stock prices do not surpass this short-term top, then prices will not move further upwards, and it is likely that a bubble will not be formed. However, it is not entirely certain how the short-term top can be recognized in advance though. The distinction I have drawn between natural and social science consists of the presence or absence of thinking participants’ who have a will of their own.

Changes in economic fundamentals, such as consumer preferences and real resource scarcity, will induce market participants to bid prices up or down based on their more or less rational expectations of what economic fundamentals imply about future prices. This process includes both positive and negative feedback between prices and expectations regarding economic fundamentals, which balance each other out at a new equilibrium price. In the absence of major obstacles to communicating information regarding economic fundamentals and engaging in transactions at mutually agreed prices, this price process will tend to keep the market moving quickly and efficiently toward equilibrium.

soros theory of reflexivity

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. 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. The two models by economist Minsky and Brunnermeier overlap in many ways with Soros’s theory of reflexivity, but there still seems to be something distinct within Soros’s model of how financial markets operate.

Far-from-equilibrium and feedback loops

Market prices of financial assets do not accurately reflect their fundamental value because they do not even aim to do so. Prices reflect market participants’ expectations of future market prices. Moreover, market participants are subject to fallibility; consequently, their expectations about the discounted present value of future earnings flows are likely to diverge from reality. This is in direct contradiction of the efficient market hypothesis, which does not admit fallibility.

The real options theory was used as a second theory of fundamental substitute that was in Calandro’s view abused by market participants. The second stage is the period of acceleration, and starts when market participants begin to recognize the trend. This awareness, in turn, changes the perception of the underlying fundamental. Calandro (2003) tells the story of Netscape, and how its spectacular IPO and subsequent rise led other entrepreneurs to build similar companies. Soros argues that this leads to a self-reinforcing process, by which the positive bias pushes stock prices into a far from equilibrium state. The NASDAQ and DJIA rose subsequently until mid-1998 when a short-term price top had build up.

Why George Soros’ Theory of Reflexivity Matters

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. While the baker’s inference about the phantom competitor turned out to be incorrect, he was following a hunch or a heuristic. On the one hand, an outside observer might say if the baker was more “rational” he wouldn’t have made such an unfounded inference. On the other hand, people need to make these kinds of inferences all the time in order to survive.

George Soros’ Top 10 Stock Picks – Yahoo Finance

George Soros’ Top 10 Stock Picks.

Posted: Thu, 15 Jun 2023 07:00:00 GMT [source]

According to Calandro, it was just a matter of time until the market would reverse given the change in policy of the Fed. The seventh stage, the climax or reversal, needs an external shock that reversed the course of the stock price. The market topped in March of 2000, and Enron and its fraudulent accounting practices, as Calandro remarks, marks one of the inflection point from which the market turned downwards.

In economics

The core principle of this book is that pluralism in the population would allow a society to seek the truth, and elect the most effective leaders who understood the truth. The real world turned out to be more complicated, because a subset of people strive not for truth but for power. Perhaps that original reading of Popper would have benefited with a read of Machiavelli’s The Prince (published in 1532).

Amidst multiple manias, panics, and crises in the 1990s and 2000s, Soros notes, was the super-bubble of credit and leverage. He originally believed that the financial crises in emerging markets during the 1990s would trigger the super bubble’s “turning point”. Instead, it continued to grow, culminating in an even greater meltdown following the subprime crisis. Soros meant for his principles to be a general description of social and economic ‘thinking’ systems. But it lends itself immediately to application and testing in finance (in part because Soros is another billionaire investor who disagrees with the efficient market hypothesis).

Calandro also remarks that the momentum during that upswing was consistently positive, reflecting enormous buying on margin. Soros received a harsh lesson in uncertainty, false truths and the vagaries of human behavior at an early age. He was a teenager when Nazi soldiers occupied his native Hungary in March 1944. Within less than two months, more than 440,000 Hungarian Jews were deported, many to Auschwitz. Of course, real life never matches up exactly with the theory’s assumptions. But they represent, economists say, a useful way of making sense of a complex world.

  • In contrast, far-from-equilibrium conditions give rise to unique, historic events in which outcomes are uncertain….
  • Giddens accentuated this theme with his notion of “reflexive modernity” – the argument that, over time, society is becoming increasingly more self-aware, reflective, and hence reflexive.
  • The most widely used are those that involve the use of leverage – both debt and equity leveraging.
  • The current economic crisis, precipitated by the corona virus pandemic, demonstrates the inherent fragility of the contemporary capitalist economic system and the drastic consequences and costs in human suffering that result from neglecting its needed reform.
  • Since perfect information does not exist (ie, we can’t predict the future and it’s impossible to know all the variables moving markets at any given time) we make our best judgements as to what assets (stocks, futures, options etc) should be valued at.

One response agents are likely to have is to suppose that cause-and-effect modelA should be replaced by some other cause-and-effect modelB and that a new Table ​Table22 applies. This is what happens in Merton’s example of the bank analyst making an influential judgment about a bank. In that case, agents had held a cause-and-effect model in which the bank’s continuing to take in deposits for the foreseeable future was the cause of the bank remaining solvent in the future. The bank analyst’s judgment, however, led depositors to expect a bank run, which meant the cause-and-effect model that predicted the bank would remain solvent no longer applied.

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