On Reflexivity

Alchemic reality

“It's not whether you're right or wrong, but how much money you make when you're right and how much you lose when you're wrong.” - George Soros

Elites use reflexive statements to create and shape subjective realities for non-elites. The thrust of Soros’s writing is that all social systems are subject to reflexivity.

In other words: it’s the Elites’ world, and the rest of humanity is just living in it.

Soros' famous theory of reflexivity, simplified

One tries to understand the world and change it to benefit oneself. The act of understanding is part of the reality one tries to comprehend so, by trying to understand, reality changes. Thus, one can never gain a full understanding of reality. 

No one can possess perfect knowledge, making all decisions imperfect. As ones understanding already causes reality to change, which makes ones initial understanding incorrect. This is the reflexive feedback loop Soros describes. 

This leads to dislocations between ones expectations/understanding and reality, as one acts on the basis of imperfect understanding. Ones map of the territory is not the territory. The map is a guide to the navigate the terrain. So, it is imperative to have a good map. 

The world is too complex for one to understand, so one uses theories, generalizations, and stereotypes to simplify reality. These heuristics are used to strip away complexities that would otherwise paralyze one from taking action. 

Reflexivity tends to be very abstract. The obfuscation of reality via abstraction has enormous implications on ones perspective of reality. These implications are especially impactful in financial markets. 

Divergence between ones understanding and reality are volatile and constantly occurring. There are misconceptions that lead to the formation of overarching trends, boom bust cycles, and exploitable opportunities for investors and speculators.

Soros' Pound coup is case in point. Some of the market participants had an imperfect understanding of the world and mistakenly thought the peg would hold. Soros, Bacon, et al recognized this imperfection and heavily bet against it.

In short, Soros uses the concept of an “underlying trend” vs the “prevailing bias’’. The bias can be taken as the expectations of traders, while the trend can be taken as fundamental reality. Soros argues that there usually tends to be a misconception which gets one of these trends started. 

The longer one sees strong earnings growth, the more market participants expect earnings growth in the future. This leads to more buying and higher stock prices. This is why the market is currently trading at such extreme multiples. The expectation is that the trend will continue until a catalyst signals otherwise. Price is a powerful purveyor of information. 

Soros also argues that higher stock prices can affect the very fundamentals they're supposed to reflect (expectations affecting reality). Admittedly, they tend to be a lot more discrete as opposed to continuous.

How does this happen?

Soros gives the example of the 1960s conglomerate bubble. 

Conglomerates would buy up other companies in stock-for-stock deals to boost earnings growth. This growth in earnings fueled higher stock prices for the conglomerate allowing it more acquisition power.

Higher stock prices=more “capital” available to take over other companies with. That helped conglomerates "buy" earnings. Eventually it all came crashing down, of course, when people realized this could not go on forever.

These cycles is the prevailing bias (expectations) tend to be "tested", through corrections, bad news, etc. If the dips get bought, then the reflexive loop gets even stronger. One last point about these boom-bust cycles is that they tend to have inflection points that lead to its end.

For example, Soros used the fact that Ogden Corp was stopped from making a certain acquisition as an inflection point to time his shorting of conglomerates. Just as they self reinforce (higher stock prices=better fundamentals=higher stock prices) on the way up, Soros says they tend to do that on the way down as well.

On amount of analysis

Soros states:

I don’t like working. I do the absolute minimum that is necessary to reach a decision.”

Soros focused on analyzing as little as possible, and knew a little about a lot of things. Soros points out that those who do too much work tend to miss out on opportunities due to analysis paralysis. They get attached to certain investments because they know them intimately. This is akin to the economic bias known as the sunk cost fallacy. The more one invested either time and or money into something the less likely they are to let it go.

On investing in "wrong" theses

As Soros states:

the fact that a thesis is flawed does not mean that we should not invest in it as long as other people believe in it and there is a large group of people left to be convinced."

There is money to be made in bubbles, as long as you manage risk. A great example of this would be buying dotcom stocks in the 1990s. The thesis is wrong, as stocks are overvalued, etc but there was a lot of money to be made being long the bubble. It was fundamentally unsound, but it worked. Again, this is why managing risk and blow up is essential.

Keynes showed this using his beauty contest idea. Soros also pointed out that

"if we find [the flaws], we are ahead of the game because we can limit our losses when the market also discovers what we already know"

Soros always tried to find what could be wrong.

On taking "starter positions"

Soros states:

"generally, we followed a process of invest first, investigate later".

He did this because either he found that his original thesis was wrong and got out with a small loss/profit, or he could build on if he was right.

On betting big

Soros states:

there was no such thing as betting too much when you were right, especially when the risk/reward was heavily in your favor.

This was the case with the pound short where his exposure was 3x the size of his fund.

“There is no point in being confident and having a small position.”

If you know the risk, the reward and you know you are right, then bet as much as possible. Soros bet $15B when shorting the GBP (about as much as the BoE would buy).

Stan Druckenmiller (Soros mentee) on liquidity

"Earnings don’t move the overall market; it’s the Federal Reserve Board… focus on the central banks and focus on the movement of liquidity...Its liquidity that moves markets"

This is key- as we saw liquidity dry up in March 2020. Liquidity reduces friction and allows markets to operate smoothly.

Stan Druckenmiller on stock analysis

“the best environment for stocks is a very dull, slow economy that the Federal Reserve is trying to get going."

We saw this during 2020. The Fed was trying to get a dull economy moving, and we've seen stocks shoot up from their March 2020 lows.

Stan Druckenmiller on finding good stocks

"And it’s margins and capacity that matter… we buy companies where we feel the margins are going to be higher in one to three years and selling companies where we feel they’re going to be lower in one to three years."

Margins and capacity were the catalysts Stan watched out for. Druckenmiller only bought companies he believed would be significantly more profitable in the next 18-24 months.

As he states:

"What’s obvious is obviously wrong… The present is already in the price"

Scott Bessent (Soros mentee) on alpha

"People always forget that 50% of a stock’s move in the overall market, 30% is the industry group, and then maybe 20% is the extra alpha from stock picking. And stock picking is full of macro bets."

A lot of value investors fail to realize that stocks tend to move just with the general market, and not necessarily because they're smart. Not everything is stock picking alpha.

Scott Bessent on the "macro" of stocks

"When an equity investor is playing airlines, he’s making an embedded macro call on oil." Everything has a macro bet. If you're buying a farming company, it's exposed to soybean/wheat/corn prices etc.”

In sum, reflexivity generally refers to the examination of one’s own beliefs, judgments and practices. If ones position refers to what one knows and believes then reflexivity is about what one does with ones knowledge. Reflexivity involves questioning one’s own taken for granted assumptions. Essentially, it involves drawing attention to the one as opposed to pretending that one did not have an impact or influence. It requires openness and an acceptance that one is part of the observation.