What is the Theory of Reflexivity? How does it work?

George Soros, a successful investor and philosopher, believes that markets are volatile due to the changing perception of all investors. According to him, these perceptions are based less on reality and more on how they perceive reality which is impacted by various macroeconomic and psychological factors. But what is this General Theory of Reflexivity? How is it helpful to traders? What are the learning from the theory?

Let’s understand the concept of Reflexivity in detail in this article.

What is Reflexivity?

To better understand its meaning in economics, let’s first learn its meaning in general. The term “Reflexivity” refers to examining one’s views, opinions, and behavior while researching and its possible influence on the research. Reflexivity is the idea of an action that returns to or impacts the originating source.

What is the Theory of Reflexivity?

To explain market movements, George Soros borrowed and adapted Karl Popper’s philosophical Theory of Reflexivity. According to him, Reflexivity contradicts most conventional economic ideas, such as equilibrium, rational expectations, and the efficient market hypothesis.

As per the Theory of Reflexivity in economics, investors base their decisions more on how they perceive reality than on reality. As a result, there is a self-fulfilling loop in which traders’ views affect the underlying principles of economic activity, impacting traders’ perceptions. 

It is premised on the following concept – price changes that significantly and persistently depart from equilibrium prices (balance of demand and supply prices) can result in feedback loops. between expectations and economic facts. For instance, rising market prices attract buyers whose purchases drive prices further higher until the cycle becomes unsustainable. This is an illustration of a positive feedback loop.

For a simple understanding of this theory, let us consider an example. Investors’ investment portfolios will alter if they believe that markets are efficient, which will change the nature of the markets in which they are trading (though not necessarily making them more efficient).

Here’s another practical example. Before the 2008 financial crisis, rising real estate prices influenced banks to increase their land mortgage lending, and, in turn, increased lending mortgages helped drive up real estate prices. As a result, a price bubble developed when rising prices were unchecked; this bubble finally burst, triggering the financial crisis and the great recession.

Key points of the Theory of Reflexivity

• Prices affect fundamentals, which in turn cause expectations to alter and ultimately affect prices. This process continues in a self-reinforcing pattern. 
• Reflexivity is based on perceptions rather than reality. Thus, facts or fundamentals are affected by the activities that follow from these beliefs, which alter investors’ perceptions and prices.
• Reflexivity challenges the concept of economic equilibrium. As prices may diverge significantly and continuously over time from the equilibrium values.

How is it applicable in the financial markets?

Let’s understand with an example. XYZ Co. is yet to generate higher revenue (according to its market valuation), but the stock price has kept rising. This is because people have developed several favorable opinions about the stock. This opinion could be because of various assumptions, such as high profitability due to innovation, increasing market share, or access to a profit switch. Or investors may keep purchasing the stock as they believe it will keep rising because of its positive past performance. 

Positive thoughts and futuristic goals encourage investors to pour money into a company that isn’t making money. Here what is important is how optimistic ideas have significantly influenced the subjective reality of XYZ company. 

Let’s go back to the original question: How does George Soros’ economic reflexivity theory apply to financial markets?

• Influence company’s value: According to the Theory of Reflexivity, a feedback loop pushes prices beyond the new equilibrium point. This impacts the company’s worth, stock price, and total asset value. 
• Formation of assets: Investors invest money because of optimistic thoughts and favorable opinions of the company, which leads to massive asset formation.
• Underlying values are reflected in stock prices: Stock prices greatly impact how much investors and businesses are worth. This influences investors and businesses to invest money.

Conclusion

To sum up, the Theory of Reflexivity is that investors form their decisions based on their perceptions rather than reality. Thus, they need to understand how market sentiment affects share pricing. As an investor, you can incorporate reflexivity into your market assessment framework. It will help you spot potentially spectacular trades more easily and alert you to big price/reality divergences just waiting to bust.

Disclaimer

1. This blog is exclusively for educational purposes
2. Investments in the securities market are subject to market risks; read all the related documents carefully before investing