Continuation in our series of portfolio management highlights from George Soros’ Alchemy of Finance – Chapter 1, Part 3: Soros introduces the theoretical foundations of reflexivity. Psychology, Intrinsic Value
“What makes the participants’ understanding imperfect is that their thinking affects the situation to which it relates…Although there is no reality independent of the participants' perception, there is a reality that is dependent on it. In other words, there is a sequence of events that actually occurs and that sequence reflects the participants' behavior. The actual course of events is likely to differ from the participants' expectations and the divergence can be taken as an indication of the participants' bias. Unfortunately, it can be taken only as an indication – not as the full measure of the bias because the actual course of events already incorporates the effects of the participants' thinking. Thus the participants' bias finds expression both in the divergence between outcome and expectations and in the actual course of events. A phenomenon that is partially observable and partially submerged in the course of events does not lend itself readily to scientific investigation. We can now appreciate why economists were so anxious to eliminate it from their theories. We shall make it the focal point of our investigation.”
“The connection between the participants' thinking and the situation in which they participate can be broken up into two functional relationships. I call the participants' efforts to understand the situation the cognitive or passive function and the impact of their thinking on the real world the participating or active function. In the cognitive function, the participants' perceptions depend on the situation; in the participating function, the situation is influenced by the participants' perceptions. It can be seen that the two functions work in opposite directions: in the cognitive function the independent variable is the situation; in the participating function it is the participants' thinking…
When both functions operate at the same time, they interfere with each other. Functions need an independent variable in order to produce a determinate result, but in this case the independent variable of one function is the dependent variable of the other. Instead of a determinate result, we have an interplay in which both the situation and the participants' views are dependent variables so that an initial change precipitates further changes both in the situation and in the participants' views. I call this interaction ‘reflexivity,’ using the word as the French do when they describe a verb whose subject and object are the same…
This is the theoretical foundation of my approach. The two recursive functions do not produce an equilibrium but a never-ending process of change…When a situation has thinking participants, the sequence of events does not lead directly from one set of facts to the next; rather, it connects facts to perceptions and perceptions to facts in a shoelace pattern. Thus, the concept of reflexivity yields a 'shoelace' theory of history.”
“Returning to economic theory, it can be argued that it is the participants' bias that renders the equilibrium position unattainable. The target toward which the adjustment process leads incorporates a bias, and the bias may shift in the process. When that happens, the process aims not at an equilibrium but at a moving target…
Equilibrium analysis eliminates historical change by assuming away the cognitive function. The supply and demand curves utilized by economic theory are expressions of the participating function only. The cognitive function is replaced by the assumption of perfect knowledge. If the cognitive function were operating, events in the marketplace could alter the shape of the demand and supply curves, and the equilibrium studied by economists need never be reached. How significant is the omission of the cognitive function? In other words, how significant is the distortion introduced by neglecting the participants' bias?
In microeconomic analysis, the distortion is negligible…When it comes to financial markets, the distortion is more serious. The participants' bias is an element in determining prices and no important market development leaves the participants' bias unaffected. The' search for an equilibrium price turns out to be a wild goose chase and theories about the equilibrium price can themselves become a fertile source of bias. To paraphrase J.P. Morgan, financial markets will continue to fluctuate. In trying to deal with macroeconomic developments, equilibrium analysis is totally inappropriate. Nothing could be further removed from reality than the assumption that participants base their decisions on perfect knowledge. People are groping to anticipate the future with the help of whatever guideposts they can establish. The outcome tends to diverge from expectations, leading to constantly changing expectations and constantly changing outcomes. The process is reflexive.”