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The Alchemy of Finance - George Soros

Guest hellsten

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Guest hellsten

[amazonsearch]The Alchemy of Finance[/amazonsearch]


I just started reading The Alchemy of Finance by George Soros (2003 version). The chapter "New Introduction" is alone worth the price of the book.


His reflexivity theory makes a lot of se

nse. I don't understand the theory fully without any experience in applying it to investments; I will try to do that in the future. It seems a lot like behavioral economics, which he also says in the new version of the book:


Behavioral economics and evolutionary game theory were far less advanced when I wrote The Alchemy of Finance than they are today. These disciplines are potentially compatible with reflexivity…


Reflexivity is a lot like self-fulfilling prophecy or a self-reinforcing process as he calls it. EMT is behind the rise in ETF and indexation. Soros agrees as far as I can tell:

Theories about human behavior can and do influence human behavior.


EMT doesn't recognize this obvious relationship between theory and behavior. He has given EMT an appropriate name "market fundamentalism".


Some other quotes:

In my investment career I operated on the assumption that all investment theses are flawed. This proposition itself is flawed…


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 proposition is that markets are almost always wrong but often they can validate themselves


I wonder what his theory or investment thesis on JCP is, maybe these comments would apply to JCP:

I should have emphasized the role of flaws and misconceptions as a key to understanding historical developments


The main similarity lies in a self-reinforcing process whereby inflated stock prices can accelerate an underlying trend, which in turn enhances expectations and inflates stock prices until the outcomes fail to sustain expectations and there is a crash


People think JCP is going bankrupt and Ackman dumping the stock and Twitter rumors reinforce this view.


It's easy to see why people, even Paul Folcker in the forewords of the book, call him a speculator.

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Guest hellsten

Really liked this post here: http://philosophicaleconomics.wordpress.com/2013/10/25/margin-debt/


Again shows how we are hardwired to see paterns everywhere while they might in fact not really be there.


Nice article. I'm reading George Soros' book on reflexivity and now I'm seeing his theories in action everywhere :D


can you please share may be one or two things that you are seeing the theory in action... just like to get a sense of if it's something I'd want to pick up a copy too thx!!  ;D


I'm seeing reflexivity in a lot of places not necessarily because it's there, but because I'm looking for it. In other words, I'm trying to learn how to identify reflexivity and I'm biased because I'm reading the book.


Some quotes about reflexivity from the book:

- Markets are always biased in one direction or another

- Markets can influence the events they anticipate

- I have to admit that the boom/bust model as it stands today is of limited use to market participants.


This is perhaps one of the more descriptive quotes:

I made a conscious effort to find investment theses that were at odds with the prevailing opinion because that is where the best profit opportunities are to be found. I defined my task as engaging in an arbitrage between my own judgment and the prevailing view.

When I identified the makings of a self-reinforcing process, I could almost feel my mouth water like one of Pavlov's dogs.


This sounds a lot like intelligent contrarian investing and behavioral investing with an emphasis on finding self-reinforcing processes, which I guess is the key to his theory. A lot of people on this board have done exactly this with BAC, FFH, OSTK, and other stocks; most investors would call it speculation or at best contrarian investing…


Another quote:

The main similarity lies in a self-reinforcing process whereby inflated stock prices can accelerate an underlying trend, which in turn enhances expectations and inflates stock prices until the outcomes fail to sustain expectations and there is a crash.

In each case, there was a misconception involved.


Reflexivity and fundamental analysis complement each other:

a reflexive model cannot take the place of fundamental analysis: all it can do is to provide an ingredient that is missing from it.

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. One provides a static picture, the other a dynamic one.

can be very useful to the investor especially if it illuminates a relationship that other investors fail to grasp.


In the case of SHLD and JCP, is the negative trend in earnings and profit the whole story, has the negative trend in the stock price and revenue affected the market's view of the stocks?


Soros gives us an example of reflexivity when he talks about the conglomerate boom:

Investors had come to value growth in per-share earnings and failed to discriminate about the way the earnings growth was accomplished. A few companies learned to produce earnings growth through acquisitions.


Sounds a lot like CRM?


My own examples:

- I was thinking of social media companies in the context of reflexivity and wondering why Zuckerberg would pay $1 billion for Instagram which had no revenue, and according to a rumor, bid $1 billion for Snapchat. The bias today in social media and tech startups seems to be to pay for the number of users a service has. Is this something we can profit from? Soros says reflexivity doesn't work well on technology stocks, because you need to understand the non-reflexive fundamental technology trends not just the bias of the market.


- In the case of JCP, while I don't know if Soros himself invested in the stock or someone who works for him, I was thinking about how reflexivity could be applied to the situation. The bias today is that Amazon will eat the world and everyone who competes with them are zombies, especially Sears and JCP. Is this view too negative? Can reality sustain expectations?


- In the case of indexation and ETFs. Isn't this just a self-fulfilling prophecy caused by EMT? EMT is the current bias and it influences the markets. Horizon Kinetics and other smart people have identified this bias and are profiting from it e.g. by buying stocks that ETFs and index funds avoid. One day investors might ask themselves "why are we investing in ETFs and index funds"?


Another example is this post:


In the United States, the experience of 1929 has ingrained the dangers of excessive margin borrowing into the market’s moral ethos.  Consequently, “too much margin” has become a story that investors instinctively tell to explain why the market falls (usually after the fact).  The story was told in the 2000s, in the 1990s, in the 1980s, in the 1970s, in the 1960s, as far back as you look.  For the most part, it’s not true.  But it doesn’t necessarily need to be true to matter; sometimes, it just needs to be believed by enough people.  And so if the chart of margin debt starts to do funky things that genuinely scare the investment community (we’re not there yet), we will need to at least pay attention, because that narrative, even if wrong fundamentally, can affect behavior, and can therefore become true reflexively.




To summarize: the key to me seems to be to find a flaw in the prevailing positive or negative bias of the market. Soros is definitely correct in saying that theory affects behavior; EMT is a self-reinforcing process.


I guess you could also summarize Soros' theory as "be paranoid"; as a WW2 survivor he is arguably pretty good at being paranoid:

I was always on the lookout for mistakes. As I mentioned earlier, it is when I did not know the flaws in my positions that I had to worry.

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.


Here's a review by the Federal Reserve Bank of St. Louis:

The helpful advice that financial economics has provided for millions of ordinary investors, to buy and hold a diversified portfolio, goes unrecognized by Soros.

Soros has deluged us with windy amateur philosophy and a profoundly

mistaken critique of economics. The great danger of the book is that non-economists will take

seriously his ill-founded criticism of economic research. Don’t buy this book.




You could argue that EMT is the opposite of being paranoid; everything is efficient so just invest in an index fund.

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