Reflexivity detected in Financial Markets – look out!

The famous investor George Soros is well-known for a theory of his known as ‘Reflexivity’. He has used this theory of his as a framework to manage his investment firm and to build a fortune over the years from the financial markets.

Soros

So what exactly is Reflexivity? Here’s the man himself explaining it in his own words:

“I have a peculiar problem in explicating my conceptual framework. 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. Circles have no beginning or end, so I have to plunge in at an arbitrary point. That makes my ideas less clear when I put them into words than they are in my own mind. I am not the only one affected by this difficulty but I feel obliged to warn the reader that this section will be more convoluted and less elegant than it ought to be; the rest of the paper is not affected.

My conceptual framework is built on two relatively simple propositions. The first is that in situations that have thinking participants, the participants’ views of the world never perfectly correspond to the actual state of affairs. People can gain knowledge of individual facts, but when it comes to formulating theories or forming an overall view, their perspective is bound to be either biased or inconsistent or both. That is the principle of fallibility.

The second proposition is that these imperfect views can influence the situation to which they relate through the actions of the participants. For example, if investors believe that markets are efficient then that belief will change the way they invest, which in turn will change the nature of the markets in which they are participating (though not necessarily making them more efficient). That is the principle of reflexivity.

The two principles are tied together like Siamese twins, but fallibility is the firstborn: without fallibility there would be no reflexivity. Both principles can be observed operating in the real world. So when my critics say that I am merely stating the obvious, they are right – but only up to a point. What makes my propositions interesting is that they contradict some of the basic tenets of economic theory. My conceptual framework deserves attention not because it constitutes a new discovery, but because something as commonsensical as reflexivity has been so studiously ignored by economists. The field of economics has gone to great lengths to eliminate the uncertainty associated with reflexivity in order to formulate universally valid laws similar to Newtonian physics. In doing so, economists set themselves an impossible task. The uncertainty associated with fallibility and reflexivity is inherent in the human condition. To make this point, I lump together the two concepts as the human uncertainty principle.”

Basically, Soros is saying that our biases and perceptions of reality can influence a sequence of events that can literally become the foundations of a new-found reality that we will operate in.

Here is the man in his own words again:

“The concept of reflexivity needs some further explication. It applies exclusively to situations that have thinking participants. The participants’ thinking serves two functions. One is to understand the world in which we live; I call this the cognitive function. The other is to make an impact on the world and to advance the participants’ interests; I call this the manipulative function. I use the term ‘manipulative’ to emphasize intentionality.

The two functions connect the participants’ thinking (subjective reality) and the actual state of affairs (objective reality) in opposite directions. In the cognitive function, the participant is cast in the role of a passive observer: the direction of causation is from the world to the mind. In the manipulative function, the participants play an active role: the direction of causation is from the mind to the world. Both functions are subject to fallibility.

When both the cognitive and manipulative functions operate at the same time they may interfere with each other. How? By depriving each function of the independent variable that would be needed to determine the value of the dependent variable. The independent variable of one function is the dependent variable of the other, thus neither function has a genuinely independent variable – the relationship is circular or recursive. It is like a partnership where each partner’s view of the other influences their behavior and vice-versa.”

Essentially, such patterns are observed because there is a lack of an independent criterion to gauge reality. Soros knows this because the markets thrive and deals on perceptions of those who participate in them.

At this current juncture, there is a gigantic reflexive relationship going on in the global financial markets. In an earlier post, I talked about a bubble in financial assets worldwide because we are in the ‘Central Banker Decade‘. Soros’ Reflexivity can clearly be seen in the fact that the markets believe central banks will do whatever they can in order to squeeze growth out of the global economy and to keep the party in asset prices going.

Think about the past 5 years since 2011. Every time an unexpected adverse event occurs, policy-makers intervene in the system, propping up the markets and assuring the world that everything will be fine (when in some cases the underlying issues still remain). Anyone betting against these interventions have either disappeared or been eliminated over the years. So, markets adapt accordingly, as they always do; creating a reflexive relationship between expectations and the actions of participants.

The concept goes something like this:

  • At first, adverse events are starting to materialise, participants panic and markets become volatile as uncertainty creeps in
  • policy-makers intervene (either directly or verbally), calming participants and the markets down
  • after some time, life goes on back to normal. But then another unexpected and adverse event occurs, participants worry again. But due to their previous experience, they worry less on aggregate. They also begin to speculate on how policy-makers would behave
  • policy-makers intervene once more (either directly or verbally), calming participants and the markets down. Participants begin to believe that this would go on everytime something similar occurs
  • and thus, a reflexive relationship is created, and markets would behave in a way that they begin to price in the effects and results of how policy-makers would react!

The best example this year was post-Brexit. Financial markets have been on risk-on mode ever since, with western equity markets continuing to eke out gains and volatility falling to lows not seen in 14 months!

However, here’s the catch. Soros says that reflexive relectionships don’t carry on to infinity. At some point they will break down and the whole thing unwinds and collapses, starting another cycle altogether. But who knows what the catalyst(s) will be?

*cover image taken from http://news.utexas.edu/sites/news.utexas.edu/files/styles/news_article_main_image/public/photos/finance_830.jpg?itok=qbWWCknD*


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