George Soros is one of the most successful asset and fund managers in the world. His net worth is US$ 25.5 billion as of May 2017. He is popularly known as the man who broke the bank of England after his huge bet against the pound during its unsuccessful transition to the Euro. Soros has claimed that a large part of his success is attributable to his theory of fallibility, reflexivity and human uncertainty principle.
This article is primarily for readers interested in the functioning of financial markets and asset pricing. If you find it is too academic or technical, you may disregard this article and move on to other interesting articles on IndianFolk.com.
What is Soros’ Theory?
There are several theories pertaining to financial markets and asset pricing. Eugene Fama’s Efficient Market Hypothesis (EFM) has been the base of most financial models and activities. However, in light of the 2008 crash, economists and academicians from other disciplines started looking for an explanation to the market’s behaviour. During their search, they stumbled upon a theory put forth by George Soros in 1987 on fallibility, reflexivity and human uncertainty.
Fama’s theory is based on assumptions such as rationality of actors and, agreement among participants on the implication of information on current prices as well as the distribution of future prices. However, this is far from reality. Man is flawed and irrational. Behavioural economists have proven this time and again. Political economists have been trying to liberate economics from these unrealistic assumptions for decades.
In contrast, Soros’ theory puts forward two principles – fallibility and reflexivity. Fallibility is that participants views never correspond to the real world. There is a subjective reality (thought) and an objective reality (reality) and these two never correspond to each other as while reconstructing the complex world we live in, man is subject to inconsistencies and biases. Scientists have proven the limits on the brain’s ability to process information. The world we live in is far too complex for one person to completely understand and reproduce in any form. Therefore, the mankind views the world as inherently imperfect.
The world is made up of thinking participants. These participants have two functions, a cognitive function (used to understand the world) and a manipulative function (used to affect change to advance interests). When these two are operating together, the element of independence is lost as each is a function of the other. This amplifies one’s imperfect views. These imperfect views that humans have can influence the situation to which they relate through their actions. This is what Soros calls reflexivity. Their actions could be statements, physicals acts, or behaviour.
Fallibility and reflexivity acting together is the uncertainty principle. Here, it is important to distinguish between risk and uncertainty. Risk is where there is perfect knowledge of future events and their probability distribution. Uncertainty is when all possible states and their probabilities are unknown.
Figure 1 shows how a reflexive system works. Since it is circular, any arbitrary point could be taken as the starting point. Based on an initial subjective reality, through the manipulative function, one tries to influence the objective reality. When the objective reality is affected, one’s subjective reality is also being affected through the cognitive function. As we know that man is fallible, both the cognitive and manipulative functions are prone to the same. Can you imagine this system with 7 billion people? You may not, but at least you know how complex it would get.
Soros distinguishes between natural phenomena and social phenomena. In the case of natural phenomena, thinking plays no causal role. There is cause effect taking place without the subjective aspect of reality. Based on the knowledge obtained, one can manipulate the natural world to attain objectives. One could plant a seed and keep watering it. One’s thoughts don’t affect the laws that govern the plant’s growth. However, social phenomena are much more complicated. Here, subjective reality can affect the objective reality due it being a reflexive system. In such a world, equilibrium is when the subjective and objective realities are the same. However, this is rarely possible. Most of the times, we reach near equilibrium points or attain temporary equilibrium.
Application in Financial Markets
Soros says that fallibility can be seen functioning in financial markets in the way assets are priced. The price of an asset never reflects its fundamental value. Prices are based on the expectations of future events besides the fundamentals.
In addition, reflexivity can be seen in the way financial markets affect reality by influencing fundamentals. A company that is high quality investment grade, if not recognized as such by the market, can be brought down to junk status due to the influence of these views on borrowing costs, etc.
Finally, there is the ‘uncertainty’ principle. Since equilibrium is rare event (or due to human’s inability to attain equilibrium), human uncertainty comes into play. A point where subjective reality and objective reality meet can be achieved through a change in subjective reality, or through a change in objective reality triggered through the manipulative function.
With these concepts, Soros explains the process of booms and busts. Booms, he says, are caused by an underlying trend coupled with a misconception relating to the trend which reinforces the trend. During the run up to the 2008 financial crisis in US and other countries, the trend was an increase in easy credit and the misconception was that property prices are independent of credit and will keep increasing. This has been seen time again in many crises. He gives the example of sovereign debt bubble in the 1980s, the Euro crisis, etc.
While the theory may seem very rudimentary and lacking the panache of economic models, it at least helps explain some of the events in the recent past. And to add to its credit, whether for good or bad, the theory has made Soros and his investors billions of dollars.
– Contributed by Bhargav
Picture: George Soros (Credits – georgesoros.com)
References: Most of the content in the article is based on an article published by George Soros in the Journal of Economic Methodology on 13 January 2014.