the Stock Market
In trying to develop a theory of reflexivity, I shall start with the stock
market. For one thing, it is the market I am most familiar with: I have
been a professional investor for more than twenty-five years. For another,
the stock market provides an excellent laboratory for testing theories:
changes are expressed in quantitative terms and the data are easily
accessible. Even the participants' views are usually available in the form
of brokers' reports. Most important, I have actually tested my theory in
the stock market and I have some interesting case studies to present.
As I mentioned in the Introduction, I did not develop my ideas
on reflexivity in connection with my activities in the stock market.
The theory of reflexivity started out as abstract philosophical speculation
and only gradually did I discover its relevance to the behavior
of stock prices. I was singularly unsuccessful in formulating my theory
at the level of abstraction at which I conceived it: my failure as a
philosopher stands in stark contrast with my career as an investment
professional. I hope that by presenting my ideas in the reverse order
from the one in which I arrived at them I may be able to avoid getting
lost in arcane abstractions.
There is yet another reason why the stock market may provide the
best entry point for the study of reflexive phenomena. The stock market
comes as close to meeting the criteria of perfect competition as any
market: a central marketplace, homogeneous products, low transaction
and transportation costs, instant communications, a large enough crowd
of participants to ensure that no individual can influence market prices
in the ordinary course of events, and special rules for insider transactions
as well as special safeguards to provide all participants with access
to relevant information. What more can one ask for? If there is any
place where the theory of perfect competition ought to be translated
into practice, it is in the stock market.
Yet there is little empirical evidence of an equilibrium or even a
tendency for prices to move toward an equilibrium. The concept of an
equilibrium seems irrelevant at best and misleading at worst. The evidence
shows persistent fluctuations, whatever length of time is chosen
as the period of observation. Admittedly, the underlying conditions that
are supposed to be reflected in stock prices are also constantly changing,
but it is difficult to establish any firm relationship between changes
in stock prices and changes in underlying conditions. Whatever relationship
can be established has to be imputed rather than observed. I
intend to use the theory of reflexivity to criticize the preoccupation of
economic theory with the equilibrium position. What better example
could I find than the stock market?
Existing theories about the behavior of stock prices are remarkably
inadequate. They are of so little value to the practitioner that I am not
even fully familiar with them. The fact that I could get by without
them speaks for itself.
Generally, theories fall into two categories: fundamentalist and
technical. More recently, the random walk theory has come into vogue;
this theory holds that the market fully discounts all future developments
so that the individual participant's chances of over- or under performing
the market as a whole are even. This line of argument has
served as theoretical justification for the increasing number of institutions
that invest their money in index funds. The theory is manifestly
false-I have disproved it by consistently outperforming the averages
over a period of twelve years. Institutions may be well advised to invest
in index funds rather than making specific investment decisions, but the
reason is to be found in their substandard performance, not in the impossibility
of outperforming the averages.
Technical analysis studies market patterns and the demand and supply
of stocks. It has undoubted merit in predicting probabilities but not
the actual course of events. For the purposes of this discussion it is of
no particular interest, because it has little theoretical foundation other
than the assertions that stock prices are determined by their supply and
demand and that past experience is relevant in predicting the future.
Fundamental analysis is more interesting because it is an out-growth
of equilibrium theory. Stocks are supposed to have a true or
fundamental value as distinct from their current market price. The fundamental
value of a stock may be defined either in relation to the earning
power of the underlying assets or in relation to the fundamental
value of other stocks. In either case, the market price of a stock is supposed
to tend toward its fundamental value over a period of time so
that the analysis of fundamental values provides a useful guide to investment
The important point about this approach is that the connection between
stock prices and the companies whose stocks are traded is assumed
to be in one direction. The fortunes of the companies
determine-however belatedly-the relative values of the various
stocks traded in the stock market. The possibility that stock market developments
may affect the fortunes of the companies is left out of account.
There is a clear parallel with the theory of price where the
indifference curve determines the relative amounts consumed, and the
possibility that the market may influence the indifference curve is disregarded.
The parallel is not accidental: the fundamentalist approach is
based on the theory of price. But the omission is more glaring in the
stock market than in other markets. Stock market valuations have a direct
way of influencing underlying values: through the issue and repurchase
of shares and options and through corporate transactions of all
kinds-mergers, acquisitions, going public, going private, and so on.
There are also more subtle ways in which stock prices may influence
the standing of a company: credit rating, consumer acceptance, management
credibility, etc. The influence of these factors on stock prices
is, of course, fully recognized; it is the influence of stock prices on these
factors that is so strangely ignored by the fundamentalist approach.
If there are any glaring discrepancies between prevailing stock
prices and fundamental values, they are attributed to future developments
in the companies concerned that are not yet known but are correctly
anticipated by the stock market. Movements in stock prices are
believed to precede the developments that subsequently justify them.
How future developments ought to be discounted is the subject of an
ongoing debate, but it is presumed that the market is doing the job correctly
even if the correct method cannot be theoretically established.
This point of view follows naturally from the theory of perfect competition.
It is summed up in the assertion that "the market is always right."
The assertion is generally accepted, even by people who do not put
much faith in fundamental analysis.
I take a totally opposite point of view. I do not accept the proposition
that stock prices are a passive reflection of underlying values, nor
do I accept the proposition that the reflection tends to correspond to
the underlying value. I contend that market valuations are always distorted;
moreover-and this is the crucial departure from equilibrium
theory-the distortions can affect the underlying values. Stock prices
are not merely passive reflections; they are active ingredients in a
process in which both stock prices and the fortunes of the companies
whose stocks are traded are determined. In other words, I regard
changes in stock prices as part of a historical process and I focus on the
discrepancy between the participants' expectations and the actual
course of events as a causal factor in that process.
To explain the process, I take the discrepancy as my starting point. I
do not rule out the possibility that events may actually correspond to
people's expectations, but I treat it as a limiting case.Translating this assertion
into market terms, I claim that market participants are always
biased in one way or another. I do not deny that markets have a predictive
or anticipating power that seems uncanny at times, but I argue that
it can be explained by the influence that the participants' bias has on
the course of events. For instance, the stock market is generally believed
to anticipate recessions; it would be more correct to say that it can help
to precipitate them.Thus I replace the assertion that markets are always
right with two others:
1. Markets are always biased in one direction or another.
2. Markets can influence the events that they anticipate.
The combination of these two assertions explains why markets may so
often appear to anticipate events correctly.
Using the participants' bias as our starting point, we can try to build
a model of the interaction between the participants' views and the situation
in which they participate. What makes the analysis so difficult is
that the participants' views are part of the situation to which they relate.
To make any sense of such a complex situation, we need to simplify
it. I introduced a simplifying concept when I spoke of the participants'
bias. Now I want to take the argument a step further and introduce the
concept of a prevailing bias.
Markets have many participants, whose views are bound to differ. I
shall assume that many of the individual biases cancel each other out,
leaving what I call the "prevailing bias."This assumption is not appropriate
to all historical processes but it does apply to the stock market
and to other markets as well.What makes the procedure of aggregating
individual perceptions legitimate is that they can be related to a common
denominator, namely, stock prices. In other historical processes,
the participants' views are too diffuse to be aggregated and the concept
of a prevailing bias becomes little more than a metaphor. In these cases
a different model may be needed, but in the stock market the participants'
bias finds expression in purchases and sales. Other things being
equal, a positive bias leads to rising stock prices and a negative one to
falling prices.Thus the prevailing bias is an observable phenomenon.
Other things are, of course, never equal. We need to know a little
more about those "other things" in order to build our model. At this
point I shall introduce a second simplifying concept. I shall postulate an
"underlying trend" that influences the movement of stock prices
whether it is recognized by investors or not. The influence on stock
prices will, of course, vary, depending on the market participants' views.
The trend in stock prices can then be envisioned as a composite of the
"underlying trend" and the "prevailing bias."
How do these two factors interact? It will be recalled that there
are two connections at play: the participating and the cognitive functions.
The underlying trend influences the participants' perceptions
through the cognitive function; the resulting change in perceptions
affects the situation through the participating function. In the case of
the stock market, the primary impact is on stock prices. The change
in stock prices may, in turn, affect both the participants' bias and the
We have here a reflexive relationship in which stock prices are determined
by two factors-underlying trend and prevailing bias-both
of which are, in turn, influenced by stock prices. The interplay between
stock prices and the other two factors has no constant: what is
supposed to be the independent variable in one function is the dependent
variable in the other. Without a constant, there is no tendency toward
equilibrium. The sequence of events is best interpreted as a
process of historical change in which none of the variables-stock
prices, underlying trend, and prevailing bias remains as it was before.
In the typical sequence the three variables reinforce each other first in
one direction and then in the other in a pattern that is known, in its
simplest form, as boom and bust.
First, we must start with some definitions. When stock prices reinforce
the underlying trend, we shall call the trend self-reinforcing;
when they work in the opposite direction, self-correcting. The same
terminology holds for the prevailing bias: it can be self-reinforcing or
self-correcting. It is important to realize what these terms mean. When
a trend is reinforced, it accelerates. When the bias is reinforced, the divergence
between expectations and the actual course of future stock
prices gets wider and, conversely, when it is self-correcting, the divergence
gets narrower. As far as stock prices are concerned, we shall describe
them simply as rising and failing. When the prevailing bias helps
to raise prices we shall call it positive; when it works in the opposite direction,
negative. Thus rising prices are reinforced by a positive bias and
falling prices by a negative one. In a boom/bust sequence we would
expect to find at least one stretch where rising prices are reinforced by
a positive bias and another where falling prices are reinforced by a negative
bias. There must also be a point where the underlying trend and
the prevailing bias combine to reverse the trend in stock prices.
Let us now try to build a rudimentary model of boom and bust. We
start with an underlying trend that is not yet recognized-although a
prevailing bias that is not yet reflected in stock prices is also conceivable.
Thus, the prevailing bias is negative to start with. When the market
participants recognize the trend, this change in perceptions will affect
stock prices. The change in stock prices may or may not affect the underlying
trend. In the latter case, there is little more to discuss. In the
former case we have the beginning of a self-reinforcing process.
The enhanced trend will affect the prevailing bias in one of two
ways: it will lead to the expectation of further acceleration or to the
expectation of a correction. In the latter case, the underlying trend
may or may not survive the correction in stock prices. In the former
case, a positive bias develops causing a further rise in stock prices and a
further acceleration in the underlying trend. As long as the bias is self-reinforcing,
expectations rise even faster than stock prices. The underlying
trend becomes increasingly influenced by stock prices and the
rise in stock prices becomes increasingly dependent on the prevailing
bias, so that both the underlying trend and the prevailing bias become
increasingly vulnerable. Eventually, the trend in prices cannot sustain
prevailing expectations and a correction sets in. Disappointed expectations
have a negative effect on stock prices, and faltering stock prices
weaken the underlying trend.
Excerpted from "The Alchemy of Finance" by George Soros. Copyright © 2003 by George Soros. Excerpted by permission. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher. Excerpts are provided solely for the personal use of visitors to this web site.