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The Alchemy of Finance by George Soros

January 14th, 2009
The Alchemy of Finance George Soros

The Alchemy of Finance George Soros

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The Alchemy of Finance

by George Soros
Originally Published in 1987

Key Takeaways

This is not an easy book to read, but it deserves your attention.  I had heard the book should be skipped because it is long winded and difficult to follow.  But Soros is such an important figure in the world of investments that I had to read his seminal book on his Theory of Reflexivity and trading activity.

Although George Soros has a brilliant mind, he’s not necessarily a brilliant writer.  He used four hundred pages for ideas that should have been expressed in two hundred pages.  I don’t regret reading the book though.  He is a philosophical man with a lot of thought provoking ideas.  I respect his Theory of Reflexivity and enjoyed learning how Soros used it to identify investment opportunities while running his Quantum Fund in the 1980s.

The book has three core parts (officially it has five parts, but I take the liberty of viewing them as three): Part One advances Soros’s Theory of Reflexivity, Part Two is a journal account of Soros’s trading activity, and Part Three includes a potpourri of philosophical meanderings on the markets.

Part One is useful for its explanation of the Theory of Reflexivity, but it should have been condensed to 1/3 the number of pages.  Part Two is excellent for its rare view into the trading mind of the most successful hedge fund manager of all time.  Part Three was largely useless – it is composed of philosophical meanderings that he will later dismiss as irrelevant or incorrect.  What was the point?

Readers looking for concrete investing strategies, similar to those provided in James Altucher’s How to Trade Like a Hedge Fund, will be disappointed. The book gives you strategies, but they come on Soros’s terms – in an abstract form.  Largely philosophical and esoteric.

I have encountered several incorrect accounts of George Soros’s Theory of Reflexivity.  Most people oversimplify the interpretation and miss a final important concept.  Read on for a clarification of the reflexivity concept and what I believe are the key takeaways of the book.  If you like what you see, I encourage you to purchase the book here.

Page – 3 New Introduction to Reflexivity

The Concept of Reflexivity: In situations that have thinking participants, there is a two way interaction between the participants’ thinking and the situation in which they participate.  The two functions can interfere with each other by rendering what is supposed to be given, contingent.

Soros calls the interference between the two functions “reflexivity”.  He views reflexivity as a feedback loop between the participant’s understanding of a situation, and the actual situation in which the they participate. Thus, situations with thinking participants are circular.

Soros claims the concept of reflexivity is especially useful when evaluating financial markets, and that the concept of reflexivity succeeds where traditional economic concepts fail.   His writing becomes philosophical and technical, but he essentially tries to refute the belief that financial markets arrive at ‘rational’ and ‘efficient’ equilibria.  He says, “The Alchemy of Finance was meant to be a frontal assault on the prevailing paradigm.”  In the end, he holds that the Theory of Reflexivity is a superior theory to the efficient market hypothesis.

Soros starts off by saying that market participants (e.g. investors’) perceptions can influence prices.  And that this is especially obvious during times of greed or fear.  Prices get bid up or sold off irrationally because of people’s perceptions.

On the surface this sounds exceedingly obvious, and is why many people dismiss Soros’s Theory of Reflexivity as worthless.  For example:

“Reflexivity is nothing more than the notion that market participants affect a price, but that prices are dynamic and constantly influenced by perception — and here’s the GREAT insight — and perception sometimes is misled by unfounded herd momentum.”

or

“His philosophical tenet, Reflexivity, denotes a feedback loop: Individuals act on their views of a situation, thereby changing the situation. For example, if traders believe a stock is going up, they buy it, thereby bidding it up. But their belief caused the result; there may be no fundamental reason for the rise. Thus what we think determines what we do and has consequences, but typically it is not correct.”

Each of these readers miss the crucial and final point in the Theory of Reflexivity’s application in the financial markets.  They miss the point that while prices may rise initially on perceptions only, that prices can affect perceptions such that perceptions begin affecting fundamentals.

This is Soros’s crucial point.  That prices affect perceptions and that perceptions affect prices and that prices in turn affect fundamentals. So perceptions affect fundamentals.  i.e. perceptions can (temporarily) make an industry ‘fundamentally’ stronger.

In Soros’s own words:

Many reviews described reflexivity by saying that prevailing sentiments greatly influence market prices.  If that were all, I would be indeed belaboring the obvious. What makes reflexivity interesting is that the prevailing bias has ways, via the market prices, to affect the so-called fundamentals that market prices are supposed to reflect.  Only when the fundamentals are affected does reflexivity become significant enough to influence the course of events.  It does not happen all the time, but when it does, it gives rise to boom/bust sequences and other far-from-equilibrium conditions that are so typical of financial markets.

If this is still confusing, let me provide an example:

Reflexivity explains why the technology boom of the late 1990s got so out of control.  From 1997 to 2002 the Nasdaq rose from 1,200 in 1997 to 5,000 in 2000 and then fell back to 1,200 by 2002. That’s a tremendous change in value in a short period of time, and cannot be explained by an ‘efficient’ and ‘rational’ market.

How did this happen?

The Soros Theory of Reflexivity says that perceptions influenced prices and that prices influenced fundamentals. But that supporting fundamentals with perceptions is eventually unsustainable and that the entire structure eventually collapsed.

Let us consider the Theory of Reflexivity in the context of the consumer Internet sector in the late 1990s.  Yahoo! pioneered the sector and started out as a healthy and profitable company offering Internet services to users and advertising space to advertisers.  As Yahoo! continued to grow, it attracted more and more users, which in turn enabled it to sell more and more advertising space to advertisers.  This increased Yahoo!’s profitability, which in turn caused investors bid up Yahoo! shares to reflect the company’s increased value.

Now Reflexivity starts to enter the picture.  Yahoo!’s success attracted a first wave of Internet startup imitators.  The first wave of Internet startup imitators were able to point to the growth and success of Yahoo! shares to raise venture capital. After raising venture capital, the first wave of Internet startup imitators purchased advertising space from Yahoo to attract new users to their web sites.  This enhanced Yahoo!’s profitability.  It also provided the first wave of Internet startup imitators the opportunity to begin selling advertisements on their own web sites.  This caused investors to bid up the shares of Yahoo! and of the first wave of Internet startup imitators.

Increasing share prices attracted more investors and a second wave of Internet startup imitators. The second wave of Internet startup imitators purchased advertising space from Yahoo! and from the first wave of Internet startup imitators.  This increased the profitability of Yahoo! and it increased the profitability of the first wave of Internet startup imitators.  Soon, Internet startup imitators were raising more and more venture capital and were purchasing more and more advertising space from each other.  You can imagine how the system perpetuated itself.  More and more advertising revenue, meant more and more investment, meant more and more web services for users, meant more and more eyeballs, meant more and more advertising dollars, meant more and more investment.  The system was self reinforcing.  And the fundamentals looked great.  Lots of revenue and profit growth – all correlated to ‘eyeballs’.  The numbers did not lie either – revenues, and in certain cases, profits, were growing smartly.  All fueled by investor perceptions that had ‘altered’ the fundamentals.

Some observers will counter, “The web services the Internet startups were providing had value.  Once they gained ‘critical mass’, the Internet startup imitators stopped purchasing advertising and could ‘self fund’ through organic web usage.  Sure, lots of investors lost money on bad companies, but that was just a consequence of speculation, i.e. funding the bad companies, instead of the good.”

Yes, some companies could stand on their own. Yahoo! was profitable and could ‘self fund’.  About.com was profitable and could ‘self fund’.  Match.com was profitable and could ‘self fund’.  And yes, thousands of other companies were doomed regardless – they would never have provided enough ‘organic’ value to stand on their own, and were probably only the result of pure speculative excess.  But there was an undeniable slice of firms in the middle that temporarily thrived on the ‘reflexive cycle’, and who only existed in the first place because of funding fueled by investor perceptions.

Reflexive systems have a way of reinforcing themselves until savvy investors start to catch on that the system is unsustainable in the long run, and pull their money or until an outside event occurs that causes a pullback.  Once savvy investors caught on to the fragile business model of Internet companies, and their reliance on venture capital derived advertising revenue, they began to pull money and the entire system was flushed of the firms that relied unduly on the ‘reflexive cycle’ for Internet advertising.  In the end, reflexive cycles end violently because perceptions can change quickly.  And when perceptions change at the end of a reflexive cycle, changes in fundamentals quickly follow.

The Alchemy of Finance covers numerous examples of reflexive boom bust systems, such as the sovereign lending boom of the 1970s where it was not recognized that credit extension enhanced the various debt ratios by which the banks measured a borrower’s creditworthiness, or the conglomerate boom where investors put a high value on earnings growth through acquisitions that reinforced the overvaluation of conglomerates, or the technology boom where investors valued top line revenue growth which could only be sustained by selling more stock at inflated prices.

I hope I have accurately described Soros’s concept of a reflexive process.

(be sure to scroll through additional pages below)

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