Thursday, May 11, 2006

>Soros & Reflexivity

Reflexivity means that any object of thought contains in itself the thinking activity that generates it. Applying the concept of reflexivity to the question of financial markets valuation, Soros concludes that economic reality is actively shaped by the perceptions of market participants. This leads him to a theory of investment radically different from other existing approaches.

The traditional explanatory structure, based on deductive logic, cannot capture reflexive processes. The fluidity and particularity that characterizes the unfolding of events do not match the constancy of logico-mathematical patterns. In reflexive processes, we cannot assume discrete entities at the bottom: any factors we isolate might not survive the process of events in their original form.

Consequently, Soros does not offer an alternative particular cut of market reality, a different set of already defined factors. Instead, he operates with that which eludes any particular cut of market reality: intrinsic uncertainty. Rather than assuming a static order, Soros embraces the lack of fixed references in his guiding principle, the belief in fallibility, meaning both the belief in his own fallibility and the belief that the misconceptions and misunderstandings that go into our decisions help shape the events in which we participate.

Soros goes beyond the denial of a static order. He asserts that the concept of reflexivity allows him to structure situations and recognize profit opportunities. These are found when the participants’ biases lead prices to diverge from an underlying trend which is itself influenced by market prices – a process which is at first self-reinforcing, then selfdefeating. However, Soros could not formulate the general theory of reflexivity he originally intended to put forth. Reflexivity remained mysterious, both at the theoretical and at the practical level: neither his conceptual framework nor the manner in which it gets translated into investment decisions is fully understandable.

Soros says us that reflexivity renders not only standard approaches to investment but also standard economic theory and the standard view of the scientific method inapplicable to the market situation. And leaves us without a clear formulation of what does apply.

Far from being trivial, formulating the reflexivity implicit in Soros’ theory and practice in positive terms requires a reversal of the usual explanatory order. Instead of reducing phenomena to structural units, this requires we take a functional view, giving primacy to functional processes that create structure, that is, viewing content as derivative of process.

AFTER THOUGHTS

Random walk theory asserts that mkt moves randomly and one cannot out perform the mkts on a risk adjusted comparision. Fundamental Value investors would say that random walk theory is useless. One needs to purchase stocks much lower than fair value and sell at fair value or when it exceeds fair value.

The theory of Reflexity goes one step ahead and asserts that thinking fundamentals is ok, even then at times non-intutive things happen due to dynamic nature of mkt. Stocks move in Long trends and feed on the frenzy and reach heights which far exceed fair values and then reverse direction. This frenzy or depression in turn effects alters the expectation and perceptions of people.

While over long term (10-20 years) stocks would tend to move in line with fundamentals even then in short term (2-5 years) the theory of reflexivity would help an investor ride many powerful trends and profit enormously. The Value in theory of reflexivity lies in the idea that markets are like an organism and donot act linearly in a predfeind manner. Markets like an dynamic organism evolve over time and this is a continouus process.

The ideas of reflexivity are not trivial to use and one needs to have deep mental models and use-cases which are linked together and also the models have room to change over time and clearly show areas where one should know that he is going wrong.

On a sumamry:
Soros genius was to look at things from a WIDE prespective and to digest huge amounts of information so as to look at things in a holistic view. Most Traders/Investors would try to use their "own restrictive system" and to view the world from their own narrow glasses. Soros approach was to study the system as a whole from as many angles as one can and to come up with teriffic models which helped him in delivering astounding returns.

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