Soros on Reflexivity

Dec, 20 2020
4 Minutes

I kept on coming across the term "reflexivity" in crypto Twitter and, not knowing what it meant, felt like I was missing an important mental model.

Turns out the idea of reflexivity was popularized by George Soros and is a seemingly obvious but exceptionally useful mental model.

Reflexivity is a form of positive feedback cycle that leads to irrational behavior: a speculator believes an asset is valuable, they buy it and drive up the price, and then viewing the rising price as evidence for being correct, the speculator forms a deeper conviction in the value of the asset.

I decided to watch Soros himself discuss reflexivity, and took some notes:

  • If we treat all drug addicts as criminals, then we generate more criminal behavior
  • There are two "functions" that give rise to reflexivity - the cognitive function (understanding) and then manipulating function (acting). When these two functions operate at the same time, they can interfere with each other, creating reflexivity
  • How? If cognition is taking in input from the world, but manipulation can affect that input, then the cognitive function becomes dependent on manipulation. And it's not hard to see how manipulation depends on cognition (you think and then you act).
  • The danger? The cognitive function can't produce enough independent knowledge to serve as useful input for the manipulative function's actions. Thus, the outcome is liable to diverge from the participant's intentions - there's slippage.
  • Slippage between intentions and actions, and furthermore, slippage between actions and outcomes.
  • When reflexivity is at play, we are blind to reality, even though we think we are not.
  • Reflexivity is about feedback loops - think microphones and speakers leading from echo to endless screeching. The serpent eating it's tail. Reflexivity destroys nuance and truth
  • Objective vs Subjective reality - objective is the one, true external world, but there can be any number of subjective views. Reflexivity only exists when there is subjective realities at play
  • Human uncertainty principle - when we act on the basis of imperfect understanding and our actions further feed back into our understanding, we're building a house of cards of reality - and our actions will start to diverge from our expectations.
  • Soros goes on and basically lays waste to classical economic theory because of the human uncertainty principle: "The subject matter of the natural and social sciences is fundamentally different, therefore they need to develop different methods and they have to be held to different standards. Economic theory should not be expected to produce universally valid laws that can be used reversely to explain and predict historic events."

That was my notes on lecture one, which was abstract. Soros mentioned that there would be more concrete stuff in the next lectures, so I decided to watch that too:

"My interpretation of financial markets directly contradicts the efficient market hypothesis"

  • Soros' principles: 1) Market prices always distort the underlying fundamentals. May be either significant or negligible 2) Financial markets have an active role and affect the "so-called fundamentals they are supposed to reflect". Financial markets can alter the fundamentals
  • Lots of ways things get mispriced - but usually because of debt and equity leverage
  • Soros' theory of booms and busts - there are two processes at work. First, there is an underlying trend that is rooted in reality, and second, a misconception that is correlated to the trend, but wrong. The trend and the misconception reinforce each other, leading to the bubble. But, the music must stop, and when it does, the trend and misconception reinforce each other, but in reverse. Instead of the trend being correlated, it is now negatively correlated. People become repulsed by the very truth they previously believed (even if it was partially correct)
  • Key to these bubbles is the passing of a "test". This test is when the first wave of skeptics bring down the price, only to be put in their place by reality. This unleashes the running of the bulls (i.e. Tesla in early 2020). If it fails the test, then the bubble stops.
  • What this means is that booming speculative premiums, which ultimately result in a collapsing bust, will create an artificially depressed purchasing opportunity once the asset's price has reached its nadir.
  • "The length and strength of each stage is unpredictable"
  • The sequence is predictable, but it can be artificially interrupted by government intervention or some other monkey wrench
  • The boom is long and drawn out - starts out gradually until it accelerates and flattens into a twilight plateau.
  • The bust is short and steep because of forced liquidations (i.e. traders on margin, foreclosures). This may cause a panic too
  • "When I see a bubble forming, I rush into buy, adding fuel to the fire - this is rational"
  • "We need regulators to counteract the market when a bubble is threatening to grow too big" - lmao, we have regulators who are pumping the bubble
  • In 2008 - a big lesson. "It cost me dearly. I got the general direction of the markets right, but I didn't allow for the volatility as a consequence I took on positions that were too big to withstand the swings caused by volatility and several times I was forced to reduce my positions at the wrong time in order to limit my risk. I would have done much better if I had taken smaller positions and stuck with them." Lesson: when you have conviction, do not go "all in" such that you'll be pressured to liquidate when you don't want to
  • "I learned the hard way that the range of uncertainty is also uncertain and at times it can become practically infinite"
  • Soros' belief that the 2008 crisis had its roots in Reagan's misconception that markets can be safely led to their devices because they are self-correcting ("the magic of the marketplace"). In the October 1987 portfolio insurance debacle, the Savings and Loan Crisis (1989-1994), the emerging market crisis of 1997/98, and the bursting of the Internet bubble in 2000 the government stepped in (via merging, monetary, or fiscal stimulus) and otherwise protected the economy from collapse. It strengthened the false belief that credit and leverage were fine to use - so long as the outcome was good. These crises proved as successful tests of faith. By the time 2008 rolled around, the government had allowed bad behavior to fester
  • Basically, we didn't have proper margin requirements and minimum capital requirements in place
  • Regulators need to monitor positional imbalances. A given trader can assume that there will always be someone on the opposite side of their position, but regulators cannot accept this from a systemic perspective. Doing so would lead to collapse when a position needs to be exited.
  • "Credit default swaps and knockout options are particularly prone to create hidden imbalances"
  • Intelligent regulation may "push proprietary traders outside of banks and into hedge funds - where they belong"

Remember, this was all in 2010 - and it feels just as relevant today as it might in 2008.