The Feedback Loop: George Soros' Reflexivity, Trend Following, and Value Investing

On September 16, 1992, George Soros cemented his place in financial history by “breaking the Bank of England,” an audacious currency trade that netted his Quantum Fund a staggering $1 billion profit. This legendary move was just one highlight in Soros’ illustrious career as a hedge fund manager, during which he consistently outperformed the market, achieving roughly 30% annualized returns over three decades from 1973 to 2000.” No wonder he has been the subject of the financial community and retail investors like me.

So, what's his secret?

Surprisingly, George Soros has been quite open about it. He credits much of his edge to his theory of reflexivity. He wrote extensively about it in his book “The Alchemy of Finance”. It was not an easy read for me. 

By writing this long article, I aim to solidify my understanding of George Soros’ investment philosophy and his theory of reflexivity.

Understanding Reflexivity

Reflexivity, in the context of financial markets, refers to the two-way feedback loop between investors’ perceptions and the fundamental realities of the market. Unlike traditional economic theories that assume markets always tend towards equilibrium, reflexivity proposes that investors’ biased views can actually change a situation’s fundamentals. In other words, market prices not only reflect reality. Market prices influence and change reality itself.

Reflexivity consists of two parts:

1. self-reinforcing stage when trends persist

2. inflection points when markets reverse forming tops and bottoms

Here is how the self-reinforcing part of reflexivity works.

1. Investors’ perceptions influence market prices.

2. Market prices then affect the underlying economic fundamentals. An example would be an over-valued company like GameStop raising massive amounts of funds from investors at inflated prices.

3. The changed fundamentals then influence investors’ perceptions again, leading to a self-reinforcing cycle that can cause prices to trend in a particular direction.

As investors’ perceptions drive prices up or down, the changing prices impact on the actual fundamentals of the asset or market. These altered fundamentals then feed back into investors’ perceptions, potentially amplifying the initial trend.

Reflexivity provides a compelling explanation for why markets tend to trend and why trend-following strategies can be effective. The feedback loop between perception and reality can create momentum that pushes prices further in one direction than rational investment models might predict. This self-reinforcing process can lead to extended periods where prices move consistently in one direction, forming the trends that trend followers seek to capitalize on.

Reflexivity suggests that these trends can persist even when prices seem disconnected from fundamental values. As the cycle continues, the gap between perception and reality may widen, potentially leading to significant overvaluations or undervaluations in the market. This phenomenon helps explain why trends can often continue longer than many investors expect, and why markets can sometimes appear irrational in the short to medium term. 

While reflexivity can drive powerful trends, these trends cannot continue indefinitely. Eventually, reality must assert itself, causing the self-reinforcing process to break down. This is how market tops and bottoms typically form. 

Here, I describe the reflexive process in which inflection points (market tops and bottoms) are formed.

1. Divergence from Fundamentals: As a trend continues, the gap between market prices and underlying economic fundamentals often widens. This divergence can reach a point where it eventually becomes unsustainable.

2. Limits of Reinforcement: The self-reinforcing process has natural limits. For instance, in a bullish trend, as prices rise, fewer investors may be willing or able to buy at ever-higher prices. Conversely, in a bearish trend, sellers may eventually exhaust their supply or reach a point where further selling seems unwarranted.

3. Catalyst for Change: Often, a specific event or realization serves as a catalyst, causing market participants to reassess their perceptions. This could be new economic data, a change in policy, or a significant world event.

4. Reversal of the Feedback Loop: When perceptions shift, the reinforcing process can quickly reverse. As some investors start to act on the new perception, their actions influence prices, which in turn affects fundamentals and other investors’ perceptions, potentially accelerating the reversal.

5. Formation of Tops and Bottoms: Market tops form when the bullish trend exhausts itself and begins to reverse. Similarly, market bottoms occur when the bearish trend runs its course and starts to turn. These inflection points often involve heightened volatility as conflicting perceptions battle for dominance.

6. New Trend Emergence: As the old trend breaks down, a new trend may begin to form, starting the reflexive process anew but in the opposite direction.

George Soros looks for inflection points(tops and bottoms) where trends may reverse. In a similar vein, value investors operate on a principle that aligns well with the eventual breakdown of reflexive trends. Like George Soros, value investors like to enter and exit at inflection points.

The value investing approach is based on the understanding that while market prices can deviate significantly from intrinsic value due to the forces of reflexivity and market sentiment, these deviations are ultimately temporary.

Here is my understanding of value investors’ behaviour based on the book “Intelligent Investor” by Benjamin Graham. Value investors, exemplified by Benjamin Graham and his most successful student Warren Buffett, view the market through the lens of “Mr. Market,” a manic-depressive character who alternates between periods of irrational exuberance and unwarranted pessimism. This personification of market behavior closely mirrors the effects of reflexivity:

• Identifying Discrepancies: Value investors actively seek situations where the market price has diverged significantly from their estimated intrinsic value of an asset.

• Contrarian Approach: When prices are driven too high by overly optimistic perceptions (the manic phase of Mr. Market), value investors may choose to sell or avoid buying. Conversely, when prices are depressed due to excessive pessimism (the depressive phase), they see opportunities to buy.

• Patience and Discipline: Value investors understand that the reflexive processes driving market trends can persist for extended periods. They must often wait patiently for reality to reassert itself and for prices to converge with intrinsic value.

• Catalyst for Profit: As the self-reinforcing cycle eventually breaks down and market perceptions shift, value investors stand to profit from the correction in prices towards intrinsic value.

• Stabilizing Force: In a sense, value investors act as a stabilizing force in the market. Their buying during periods of pessimism and selling (or refraining from buying) during periods of exuberance can help dampen the extremes caused by reflexivity.

• Long-term Perspective: The value investing approach inherently acknowledges that while reflexivity can drive short to medium-term trends, fundamentals ultimately matter in the long run.

George Soros and Warren Buffett share a common approach when it comes to identifying and capitalizing on market inflection points, despite their different overall investment strategies. Both recognize the importance of these critical junctures where trends may reverse, offering potentially lucrative opportunities.

Soros actively seeks out inflection points (market tops and bottoms). As he explains, “Most of the time I am a trend follower, but all the time I am aware that I am a member of the herd and I am on the lookout for inflection points”

Value investors, similarly, wait patiently for these moments when market prices significantly diverge from their calculated intrinsic values. They view these disparities as opportunities to buy undervalued assets or sell overvalued ones, essentially betting on the market’s eventual return to fundamental values.

I am qualified to say this, from painful experience, that trying to identify inflection points and going against prevailing trends is very risky. It can even be fatal. I lost a lot of money trying to do this in my early days. After reading Benjamin Graham’s Intelligent Investor, I had grand illusions and underestimated Mr Market, thinking that he was a manic-depressive mental nutcase. What was cheap got cheaper. What saved me from becoming a mental nutcase was risk management born from a conservative nature. Soros himself said “Most of the time we are punished if we go against the trend. Only at an inflection point are we rewarded”.

Value investors and macro investors like George Soros primarily profit by identifying and acting on the inflection points in the reflexivity process. On the other hand, trend followers capitalize on the reinforcing stage of the reflexivity process. During this phase, perceptions and market prices mutually reinforce each other, creating sustained trends. In contrast to value investors, trend followers excel at identifying these trends early, riding them for substantial profits, and exiting after the trend reverses.

What if one becomes a master of both? Become experts in identifying inflection points and riding the trends during the reinforcing reflexive stage?

Indeed, while understanding both trend-following and inflection point identification can be powerful, there's wisdom in focusing one's efforts to be a specialist. As the legendary martial artist Bruce Lee famously said, "I fear not the man who has practiced 10,000 kicks once, but I fear the man who has practiced one kick 10,000 times." His philosophy emphasizes the value of deep expertise in a single area over superficial knowledge of many.

In conclusion, George Soros' theory of reflexivity has helped me in gaining a deeper understanding of financial markets. By highlighting the two-way feedback loop between investors' perceptions and market realities, reflexivity explains the formation of trends, the persistence of market inefficiencies, and the eventual creation of inflection points (tops and bottoms).

The parallels between Soros' search for inflection points and value investors' contrarian approach underscore a fundamental truth in investing: markets can deviate significantly from fundamental values, but they tend to correct over time.