Understanding George Soros’ Theory of Reflexivity in Markets

My conceptual framework enabled me both to anticipate the crisis and to deal with it when it finally struck. It has also enabled me to explain and predict events better than most others. This has changed my own evaluation and that of many others. My philosophy is no longer a personal matter; it deserves to be taken seriously as a possible contribution to our understanding of reality. ~ George Soros (via FT)

What Is George Soros’ Reflexivity Theory? 

The conceptual framework that Soros is referring to in the above quote is Reflexivity. Understanding what Soros’ reflexivity is, and how it affects markets (and much more) is one of the most important fundamental truths a trader can grasp.  

The idea is centered around there being two realities; objective realities and subjective realities.


What Are Objective Realities? 

Objective realities are true regardless of what participants think about them. For example, if I remark that it’s snowing outside and it is in fact snowing outside, then that is an objective truth. It would be snowing outside whether I said or thought otherwise — I could say it’s sunny but that would not make it sunny, it would still be snowing.


What Are Subjective Realities? 

Subjective realities on the other hand are affected by what participants think about them. Markets fall into this category. Since perfect information does not exist (ie, we can’t predict the future and it’s impossible to know all the variables moving markets at any given time) we make our best judgements as to what assets (stocks, futures, options etc) should be valued at. Our collective thinking is what moves markets and produces winners and losers. This means that what we think about reality affects reality itself. And that reality in turn affects our thinking once again.


Soros’ Reflexivity Theory Applied To Real World Examples 

Have I lost you? Stay with me, it’s not as complicated as it sounds.

Take a highflying tech stock like Amazon (AMZN) for example. The company has made little in the way of income (in relation to its market cap) for the majority of its existence (over 15 years) but the stock has continued to soar. This is happening because people formed a number of positive beliefs about the stock. These beliefs could be that the company will make tons of money someday because it’s innovative, eating market share, or has a secret profit switch it can flip whenever it wants. Or maybe people continue to buy the stock because it’s gone up for a long time and so they assume it will continue to go up.

In truth it’s probably many of these reasons that encourage investors to continue piling into a profitless company. But the reasons aren’t important. What’s important is that these positive beliefs have directly affected Amazon’s subjective reality.


Here are just a few examples of how Amazon’s fundamentals have been positively affected by investors’ beliefs:

  • The high stock price has allowed the company to receive cheaper financing costs
  • And attract exceptional talent which in turn has lead to increased growth
  • And hide costs by including stock options as a large portion of employee compensation
  • And be unconcerned with profits, enabling them to drastically undercut competition and steal market share


It’s not difficult to imagine another reality in which investors collectively had a more negative or neutral belief about the company. Amazon may look very different today. Forced to focus on profits — like many businesses — Amazon perhaps would not have had the explosive growth its experienced. Maybe it never would have expanded outside of selling books. Maybe a competitor would have run it out of business.

The point is that since markets are reflexive, our beliefs about them directly affect the underlying fundamentals and vice-versa. And sometimes the reflexive mechanism forms a powerful feedback loop which causes prices and expectations to drastically diverge from reality.


Here is Soros on Reflexivity:

Financial markets, far from accurately reflecting all the available knowledge, always provide a distorted view of reality. This is the principle of fallibility. The degree of distortion may vary from time to time. Sometimes it’s quite insignificant, at other times it is quite pronounced.

Every bubble has two components: an underlying trend that prevails in reality and a misconception relating to that trend. When a positive feedback develops between the trend and the misconception, a boom-bust process is set in motion. The process is liable to be tested by negative feedback along the way, and if it is strong enough to survive these tests, both the trend and the misconception will be reinforced.

What Soros is saying is that markets are in a constant state of divergence from reality — meaning, prices are always wrong. Sometimes this divergence is miniscule and hardly perceptible. Other times this divergence is large, due to feedback loop drivers. These are the boom and bust processes. And it is these large divergences that we as traders want to seek out, because that’s where the money is.

You need to learn how to identify the themes that are ripe for a strong feedback loop to form; where positive perceptions directly boost fundamentals. These are the scenarios where a stock or sector will go parabolic. And Soros again:

Usually some error in the act of valuation is involved. The most common error is a failure to recognize that a so-called fundamental value is not really independent of the act of valuation. That was the case in the conglomerate boom, where per-share earnings growth could be manufactured by acquisitions, and also in the international lending boom where the lending activities of the banks helped improve the debt ratios that banks used to guide them in their lending activity.


Applying Soros’ Reflexivity Theory

Make reflexivity a part of your mental-model for evaluating markets. Not only will it allow you to better identify potentially fantastic trades, but it will also make you aware of already large price/reality divergences that are ripe for a bust.

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Brandon Beylo

Value Investor

Brandon has been a professional investor focusing on value for over 13 years, spending his time in small to micro-cap companies, spin-offs, SPACs, and deep value liquidation situations. Over time, he’s developed a deeper understanding for what deep-value investing actually means, and refined his philosophy to include any business trading at a wild discount to what he thinks its worth in 3-5 years.

Brandon has a tenacious passion for investing, broad-based learning, and business. He previously worked for several leading investment firms before joining the team at Macro Ops. He lives by the famous Munger mantra of trying to get a little smarter each day.


Investing & Personal Finance

AK is the founder of Macro Ops and the host of Fallible.

He started out in corporate economics for a Fortune 50 company before moving to a long/short equity investment firm.

With Macro Ops focused primarily on institutional clients, AK moved to servicing new investors just starting their journey. He takes the professional research and education produced at Macro Ops and breaks it down for beginners. The goal is to help clients find the best solution for their investing needs through effective education.

Tyler Kling

Volatility & Options Trader

Former trade desk manager at $100+ million family office where he oversaw multiple traders and helped develop cutting edge quantitative strategies in the derivatives market.

He worked as a consultant to the family office’s in-house fund of funds in the areas of portfolio manager evaluation and capital allocation.

Certified in Quantitative Finance from the Fitch Learning Center in London, England where he studied under famous quants such as Paul Wilmott.

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Macro Trader

Founder and head macro trader at Macro Ops. Alex joined the US Marine Corps on his 18th birthday just one month after the 9/11 terrorist attacks. He subsequently spent a decade in the military. Serving in various capacities from scout sniper to interrogator and counterintelligence specialist. Following his military service, he worked as a contract intelligence professional for a number of US agencies (from the DIA to FBI) with a focus on counterintelligence and terrorist financing. He also spent time consulting for a tech company that specialized in building analytic software for finance and intelligence analysis.

After leaving the field of intelligence he went to work at a global macro hedge fund. He’s been professionally involved in markets since 2005, has consulted with a number of the leading names in the hedge fund space, and now manages his own family office while running Macro Ops. He’s published over 300 white papers on complex financial and macroeconomic topics, writes regularly about investment/market trends, and frequently speaks at conferences on trading and investing.

Macro Ops is a market research firm geared toward professional and experienced retail traders and investors. Macro Ops’ research has been featured in Forbes, Marketwatch, Business Insider, and Real Vision as well as a number of other leading publications.

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