The Alchemy of Finance

The Alchemy of Finance

by George Soros

ISBN: 9780471445494

Publisher Wiley

Published in Business & Investing/Accounting, Business & Investing/Finance, Business & Investing/Economics, Business & Investing/Investing

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Book Description

George Soros is unquestionably the most powerful and profitable investor in the world today. Dubbed by BusinessWeek as "The Man Who Moves the Markets," Soros has made a billion dollars going up against the British pound. Now, in The Alchemy of Finance, he shares the investment strategies he uses to read the mind of the market.


Sample Chapter

Chapter One

Reflexivity in 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 decisions.

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 underlying trend.

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.
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