George Soros’ theory of Reflexivity

Like Warren E Buffett at 79 years of age, George Soros is another widely followed old billionaire and investment guru.

For those of you who haven’t heard of him before here’s a quick rundown.

Soros escaped Nazi Germany and began his working life working in London as a stockbroker and went on to become a successful hedge fund manager and currency trader.

He migrated to the United States in 1956 and while continuing to climb the trader/hedge fund manager ladder he developed his theory of reflexivity. In 1969 he formed an investment company that later formed into the enormously successful funds management business the Quantum Fund.

The Quantum Fund returned better than 42% average yearly returns for 10 years, the explanation for such outsized returns Soros says is his Reflexivity Theory.

George received the greatest notoriety for his short selling of 10 billion pounds sterling on Black Wednesday 1992.

The Bank of England withdrew the currency from the European Exchange Rate Mechanism netting Soros a cool US$1.1 billion. As a result George was dubbed ‘the man who broke the Bank of England’.

The man with a theory

First penned in 1987 The Alchemy of Finance George’s introduced us to his theory of Reflexivity. George uses this as the basis of all his investment decisions.

His theories and predictions developed in the book are eerily relevant to current events.

Using the earnings cycle as an example to understanding Reflexivity we can see how the market is biased in one direction or another and that markets can influence the events they anticipate.

This can also be followed using an individual company or market sector (such as the housing market) or anything that is influenced by public opinion for that matter.

Act 1

An earnings trend is developing and yields are heading up but no one has recognised it yet.

Act 2

Let’s get this party started – the underlying earnings trend is recognised.

Act 3

Testing time – The earnings trend is tested but reasserts itself (this can occur more than once due to a number of factors such as sellers reaching their time horizon and breakeven point).

Act 4

Test passed – Conviction that the market believes the earnings trend will continue with rising forecasts in earnings.

Analysts by the story line from management that the earnings hiccup was just a ‘blip’.

Act 5

The Boom – No one realises it yet but the party’s practically dead already. The music’s too loud and neighbours have called the police.

This is the period where the most “buy” recommendations are written and the most favourable press coverage occurs. The share or sector becomes popular for being popular.

If you find that difficult to grasp think of it like this, Paris Hilton is famous because people pay attention to her. Everyone pays attention to her because she’s famous. The cycle feeds off itself.

Expectations continue for earnings growth which are not sustained with reality. Signs of losses start creeping in.

Act 6

Everyone scrambles for the exits, negative press articles appear and financiers, lenders, etc start calling in their loans.

The underlying earnings reversal reinforces the downward price spiral.

Act 7

Bust mode then back to acts 1 and 2 – The pessimism of the market becomes overdone. (Usually because participants don’t understand ‘price’ in relation to ‘value’) Analysts’ drop their coverage.

History repeats

As sure as the snowflake’s returning to the Victorian mountains every winter and the ocean tides coming in and out the cycle goes on given the self-reinforcing mechanisms that create the boom and then cause the bust.

Does it all sound too simple? Well that’s because it is or as Warren E Buffett says “investing is simple, but not easy”.

Soros calls this theory “Reflexivity,” and he has successfully applied it to equity, fixed-income, and currency markets.

Soros earnings cycle has no fixed time frame and some of these periods may pass very quickly.

Likewise smart entrepreneurs should recognise how the pattern works and not get caught in acts 5 and 6. Smart SMEs never believe anyone who tells you “this time, it’s different”.

Monitor your portfolio closely yourself and speak regularly with an intelligent adviser whose judgement you can trust.

Nick Christian is a Financial Adviser and planner and authorised representative of Millennium3 Financial Services.

The views and opinions expressed within this letter are those of the author and do not necessarily reflect those of Millennium3 Financial Services Pty Ltd.

The above is general in nature and should not be acted upon without seeking the advice of a professional licensed financial planner.