The Alchemy of Finance by George Soros
Difficult read and wouldn't recommend to a beginner who is trying to learn the markets and investing. I read it in my late 20's when I had a better understanding of markets and it was really influential to my thinking. George Soros is one of the most famous traders and is probably remembered most for making a billion dollars off one trade when he shorted the British pound. He has a theory of how the markets work called reflexivity where a two way feedback loop exists between market participants whose thinking affects the market environment which in turn changes the market participants thinking.
Understanding reality, and financial markets in particular, is a never-ending process.
As it is, the world in which we live is, to some extent, our own creation.
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.
As we have seen, people based their actions on a reality but the on their view of the world, and the two are not identical. As a result even past history cannot be treated in the same way as natural phenomena because it does not consist only of hard facts like the birth and death of Kings. Social situations like revolutions or political compromises have different meanings for different participants, and even after the event they are subject to different interpretations.
Theories about human behavior can and do influence human behavior.
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.
In my investment career I operated on the assumption that all investment thesis are flawed. This proposition itself is flawed; it does not follow from the human uncertainty principle that all theories are flawed. But is very useful assumption to work with.
Where I have something significant to add is in pointing out that it pays to look for the flaws; if we find them, we are ahead of the game because we can limit our losses when the market also discovers what we already know. It is when we are unaware of what could go wrong that we have to worry.
My son is right about the back ache. 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.
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.
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.
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.
Existing theories about the behavior of stock prices are remarkably inadequate. They are of so little value to the practitioner that I'm not even fully familiar with them. The fact that I could get by without them speaks for itself. Generally, theories fall into two categories: fundamentalist and technical. More recently, the random walk theory has come into vague; this theory holds that the market fully discounts all future development so that the individual participants's chances of over or under performing the market as a whole are even. This line of argument has served as theoretical justification for the increasing number of institutions that invest their money in index funds. The theory is manifestly false - I have disproved it by consistently outperforming the averages over a period of 12 Years. Institutions may be well advised to invest in index funds rather than making specific investment decisions, but the reason is to be found in their substandard performance, not in the impossibility of outperforming the averages.
I take a totally opposite point of view. I do not accept the proposition that stock prices are a passive reflection of underlying values, nor do I accept the proposition that the reflection tends to correspond to the underlying value. I contend that market valuations are always distorted; moreover - and this is the crucial departure from equilibrium theory - the distortions can affect the underlying values. Stock prices are not merely passive reflections. They are active ingredients in a process in which both stock prices in the fortunes of the companies who stocks are traded are determined. In other words, I regard changes in stock prices as part of a historical process and I focus on the discrepancy between the participants' expectations and the actual course of events as a casual factor in that process.
I claim that market participants are always biased in one way or another.
Without knowing anything about the fundamentals we can make some worthwhile generalizations. The first generalization is that stock prices must have some effect on the fundamentals whatever they are, in order to create a boom / bust pattern. Sometimes the connection is direct as in the examples I shall use in this chapter but generally it is indirect... The second generalization is that there is bound to be a floor in the participants' perception of the fundamentals. The floor may not be apparent in the early stages but is likely to manifest itself later on.
What the flaw is and how and when it is likely to manifest itself are the keys to understanding boom / bust sequences.
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.
Investors operate with limited funds and limited intelligence: they do not need to know everything. As long as they understand something better than others, they have an edge.
The greatest problem in reflexivity analysis is to decide what elements to single out for attention. And dealing with a financial market the problem is relatively simple. The critical variable is the market price and the elements that need to be considered are those that influence market prices. But even here the number of factors that may come into play is almost infinite.
My brief account of recent events is sufficient to show that regulators are not exempt from bias. They are participants in a reflexive process and operate on the basis of imperfect understanding, just like those whom they regulate. On balanced the regulators understand the business they supervise less well than those who engage in it. The more complex and innovative that business is, the less likely that the supervisory authority can do a competent job. Regulation always lags behind events. By the time regulators have caught up with excesses, the corrective action they insist on tends to exasperate the situation in the opposite direction... by the time the authorities discovered that international lending was unsound it was too late to correct the situation because the correction would have precipitated a collapse.
The combination of a near-term negative and a long-term positive impact is called a J curve
[My note: George Soros on the anxiety of being a hedge fund manager] "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.... 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. [My note: Last sentence was written on October 22, 1986]
[October 22, 1986] 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 clearly out 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.
We may generalize from the easiest decision, formulate a hypothesis that we live in a financial system that tends to go to the bank and then recoil. It's that past suspense and well within the tendency of our economy to flirt with reception and then to rebound without gathering real strength. There is a logical connection between the two tendencies: it is the danger of a recession that prompts remedial action. Although we can expect the system to recover from the brink every time it gets there, we cannot be sure; and the more confident we become, the greater is the danger that it will not. We could call this a system of self-defeating prophesies.
Indiana expansionary phase - recessions are induced by the monetary authorities in their attempt to cool off an overheated economy.
Page 307 - Phase one shows my approach at work when it is successful, Phase 2 when it is not.
Phase 2 is dominated by one major mistake: my reluctance to recognize that the "bull market of a lifetime" has run its course. The consequences were particularly paid for by Japan where I was participating in a classic boom / bust sequence and failed to get out in time. Once committed, the mistake was difficult to rectify; but at least the analytical framework made me aware of what I was up against.
I was greatly helped by the discipline of having to write down my thoughts. My arguments made us strike the reader as particularly well organized, but they are certainly more consistent and they would have been if I had not taking the trouble to formulate them in writing.
To bring the point home, I have described the alternative method of alchemy. Scientific method seeks to understand things as they are, while alchemy seeks to bring about a desire state of affairs. To put it another way, the primary objective of science is the truth - that of alchemy, operational success.
Nature obeys laws that operate independently of whether they are understood or not; the only way man can bend nature to his will is by understanding and applying these laws... But social phenomena are different: they have thinking participants. Events do not obey laws that operate independently of what anybody thinks. On the contrary, the participants' thinking is an integral part of the subject matter.
The real-time experiment shows that my approach is more successful in dealing with financial markets than with the real world. The reason for this: financial markets themselves functioning perfectly as a mechanism for predicting events in the real world. There was always a diversions between prevailing expectations in the actual course of events. Finish success depends on the ability to anticipate prevailing expectations and not real world developments. But, as we have seen, my approach really produces firm predictions even about the future course of financial markets, it's only a framework for understanding the course of events as they unfold if it has any validity it is because the theoretical framework response to the way the financial markets operate. That means that the markets themselves can be viewed as formulating hypothesis about the future and then submitting them to the test of the actual course of events. The hypothesis that survive the test remain; those that fail are discarded. The main difference between me and the markets is the market seem to engage in a process of trial and error without the participants fully understanding what is going on, while I do it consciously. Presumably and that is why I can do better than the market.
Financial markets constantly anticipate events, both on the positive and the negative side, which failed to materialize exactly because they have been anticipated.
The presence of thinking participants complicates the structure of events enormously: the participants' thinking affects the course of events and the course of events affect the participants' thinking. To make matters worse, participants influence and affect each other. If the participants' thinking bore some determinate relationship to the facts there would be no problem: the scientific observer could ignore the participants thinking and focus on the facts.
I want to focus on one particular weakness of the market mechanism: it's in an instability. Its causes have been identified: it's a rise from them to a connection between thinking and reality that I have labeled reflexivity. It is not in operation in all markets at all times; but if and when it occurs, there is no limit to how far away both perceptions can move from anything that could be considered equilibrium.
I have presented evidence that unregulated financial markets tend to become progressively more unstable. The evidence is most clear cut in the currency markets, but it is also quite persuasive with regard to the expansion and contraction of credit. Whether stock markets would prove inherently unstable if there were no credit involved remains an open question, because stock market booms are always associated with credit expansion. Excessive instability can be prevented only by some sort of regulation. How much instability is excessive is a matter of judgment. Standards vary with time.... the trouble with regulation is that the regulators are also human, and apt to err.
Experience shows that every system - be it the gold standard, Bretton Woods, or freely floating exchange rates - has broken down when it was not supported by the appropriate economic policies. Is equally difficult to see how economic policies could correct the prevailing imbalances without some sort of systemic reform. The virus and balances are interconnected and it is impossible to deal with one without affecting the others... some of these instabilities are caused by economic policies and can be altered only by pursuing different once; others are inherent in the prevailing system and can be cured only by changing the system.
The fear of death is one of the most deeply felt human emotions. We find the idea of death totally unacceptable and we grasp at any straw to escape it. The striving for permanence and perfection is just one of the ways in which we seek to escape death. It happens to be a deception. Far from escaping the idea of death we embrace it; permanence and perfection are death.
The predominance of economic values in western western societies itself are a function of our economic success. Values evolve in at reflexive fashion: the fact that economic activity has borne positive results has enhanced the value we put on economic values. The same can be said about scientific method: the triumphs of natural science have raised the status of scientific method to unsustainable heights. Conversely, various forms of art have played a much bigger role in cultures not very far removed from our own just because it was easier to achieve positive results in art and then an economic activity. Even today, so she carries away in Eastern Europe, including the Soviet Union, and we find difficult appreciation in the west. There's little doubt in my mind that our emphasis on material values, profit, and efficiency has been carried to an extreme. Reflexive processes are bound to lead to excesses, that is impossible to define what is excessive because it matters of values there is no such thing as normal. Perhaps the best way to approach this other device is to start from the position that they are rude and fantasy rather than reality. As a consequence, every set of values has a flaw in it.
Values are closely associated with the concept of self - a reflexive concept if ever there was one. We think has a much greater bearing on what we are then on the world around us. But we are not possibly correspond to what we think we are, but there is a two-way interplay between the two concepts. As we make our way in the world our sense of self evolves. The relationship between what we think we are and what we are in reality is the key to happiness - in other words, it provides the subjective meaning of life.
It will come as no surprise to the reader when I admit that I have always harbored an exaggerated view of my self importance - to put it bluntly, I fancy myself as some kind of God or an economic reformer like Keynes (with his general theory) or, even better, a scientist like Einstein (reflexivity sounds like relativity). My sense of reality was strong enough to make me realize that these expectations were excessive and I kept them hidden as a guilty secret. This was a source of considerable unhappiness through much of my adult life. As I made my way in the world, reality came. To my fantasy to all the way through in my secret, at least to myself. Needless to say, I feel much happier as a result.
Reality falls far short of my expectations, as the reader can readily observed, but I no longer need to harbor a sense of guilt. Writing in this book, and especially these lines, exposes me like I never dared to expose myself before, but I feel like I can afford it: my success in business protects me. I am free to explore my abilities to their limits, exactly because I do not know where those limits are. Criticism will help me in this endeavor. The only thing that can hurt me is if my success encouraged me to return to my childhood fantasies of omnipotence - but that is not likely to happen as long as I remain engaged in the financial markets, because they constantly remind me of my limitations.
I start from the position that every human endeavor is flawed: if we were to discard everything that is flawed there would be nothing left.
I just came back from China where the issues are of vital significance. The country has passed away horrendous during which the collective terrorize the individual on a massive scale. Is now run by people who are there on the receiving end of terror. These people have ample reason to be passionately devoted to the cause of individual freedom; but they're up against a long tradition of feudalism, and all pervasive bureaucracy, and the constraints of Marxist ideology.
Participants as a monopoly on truth, the best arrangement allows for a critical process in which conflicting views can be fully debated and eventually tested against reality. Democratic elections provide such a form in politics, in the market mechanism provides one in economics. Neither markets nor elections constitute an objective criterion, only an expression of the prevailing bias; but that is the best available in an imperfect world.