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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

Buy From Amazon:
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.”


“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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Trend Following: How Great Traders Make Millions in Up or Down Markets by Michael Covel

January 6th, 2009
Trend Following Michael Covel

Trend Following Michael Covel

Buy From Amazon:
Trend Following: How Great Traders Make Millions in Up or Down Markets
by Michael W. Covel
Published in 2005

Key Takeaways

I’ve read a lot of investing books.  And this may well be the worst.  All fluff and no substance.  Reminded me of a bad high school English paper that spams the reader with superfluous words and narrow margins to meet a page count requirement.  After 150 pages, I seriously considered abandoning the book and moving on. But its in my DNA to finish any book I start, so I tortured myself skimming the last 250 pages of uselessness.

Trend Following is an excellent trading strategy and deserves to be studied.  But Covel, in Trend Following, is not the way to learn.  Covel goes in circles gushing about how great Trend Following is and about how great the Hedge Fund managers are that employ Trend Following.  But he sounds much more like a starstruck high school girl with a teenage crush than a trading guru.  He never gets around to giving us the beef.

Definitely don’t buy this book, you can get what you’re looking for in this post where I profile the techniques he covers, or you can read my post on ‘The Slow Turtle Trade‘ from James Altucher‘s book How to Trade Like a Hedge Fund.  When I find a good Trend Following book, I will update this post.

The one thing Covel did well was collect some excellent quotes on Finance, Trading and Investing.  He included at least two quotes per page (presumably to make up for lack of original material and to boost his page count).  For this, I was grateful and have provided the best in my post on Finance Quotations.

Page 266 – Trend Following Systems

(Yes, it took Michael Covel until 266 pages into his 400 page book to write anything worth remembering.)

Fast Simple Moving Average (SMA) Crossover of the Slow Simple Moving Average

  • Buy the index when the Fast SMA (50 day) crosses over the slow SMA (100 day)
  • Sell and then go short when the fast SMA (50 day) crosses under the slow SMA (100 day)
  • Set a stop loss of four times the Average True Range (ATR) of 10 days

Note: The stop loss risk control avoids a loss of more than 2% of equity

Note: The True Range is the absolute value of the greatest of the following:

  • The distance from today’s high to today’s close
  • The distance from yesterday’s close to today’s high
  • The distance from yesterday’s close to today’s low

The Average True Range calculates the Simple Moving Average to the True Range.

Backtesting this trade from November 2001 to March 2002 results in a an average annualized return of 19.6% with a maximum drawdown of 46%.  But less than 40% of the system’s trades are profitable.  Using sensitivity analysis for the number of days to use in the Fast and Slow SMA, combinations in the 40 – 60 fast SMA days and 100 – 120 slow SMA days provide the best results.

Fast Simple Moving Average (SMA) Crossover of the Slow Simple Moving Average with Pattern Entry

This system combines trend following and countertrend concepts.  It is called Trend with Pattern Entry (TPE) and was first introduced by Dion Kurczek and Volker Knapp in Active Trader Magazine in April 2003.  The premise is that prices above the SMA indicate a bull trend, but should only be bought on countertrend pullbacks.  Similarly, prices below the SMA indicate a bear trend, but should only be sold short into countertrend rallies. The prices wait for three consecutive countertrend (down or up) days before entering the market.

  • Buy the index if the price is above the 100 day SMA and the closing price decreased over the last three days.
  • Exit the position (sell) if the price reaches the trailing stop, which is 4 times the ATR of 10 days subtracted from the current closing price.
  • Then short the index if the price is below the 100 day SMA and the closing price increased during the last three days.
  • Exit the position (buy to cover) if the price reaches the trailing stop, which is 4 times the ATR of 10 days added to the current closing price.

Backtesting this trade from October 2000 when the market experiences a strong up-move three times in a row while still below the SMA.  The system starts short and finally ends in early 2002.  The system generates 21.8% annualized returns, but experiences several drawdowns of over 20% and one of 49%. Indeed, large drawdowns are the biggest challenge for Trend Following systems.  The large drawdowns are why investors are instructed to Trend Follow a basket of uncorrelated assets and commodities.  If an investor were to get hit by highly correlated large drawdown across all investment classes, it could wipe them out.

There are several variations to these techniques such as Pyramiding, or adding to a position shortly after the trend is validated and proved profitable.

Remember, the best part of the book are the quotes Covel collected, so be sure to visit my post on Financial Quotations.


Getting Started in Currency Trading, by Michael Archer and Jim Bickford

December 30th, 2008
Getting Started in Currency Trading Michael Archer Jim Bickford

Getting Started in Currency Trading Michael Archer Jim Bickford

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Getting Started in Currency Trading: Winning in Today’s Hottest Marketplace
by Michael D. Archer and Jim L. Bickford
Published in 2005

Key Takeaways
In this post I summarize what I believe are the key takeaways of the book. If you like what you see, I encourage you to buy the book.  The book is an excellent introduction to currency trading.  Even if you don’t trade currencies, its a worthwhile read for any investor – especially if you are an active trader.  The book includes trading insights, regardless of what you trade or invest in.  The book is a quick read and the chapters are short and straightforward.

Note: the pages referenced in this post are from the 1st Edition published in 2005.  However, there is a newer edition published in 2008, that you would likely want to buy instead.

Page 28 – What Every Trader Must Know – Forex Terms
Every Forex trade involves the simultaneous buying of one currency and the selling of another currency.  These two currencies are always referred to as the currency pair in a trade.  The seven most frequently traded currencies are called the major currencies (USD, EUR, JPY, GBP, CHF, CAD, and AUD). The most frequently traded minors are the New Zealand dollar (NZD) the South African rand (ZAR), and the Singapore dollar (SGD).

The base currency is the first currency in any currency pair.  It shows how much the base currency is worth as measured against the second currency.  For example, if the USD/CHF rate equals 1.6215, the one USD is worth CHF 1.6215. The quote currency is the second currency in any currency pair.  This is frequently called the pip currency and any unrealized profit or loss is expressed in this currency.  A pip is the smallest unit of price for any currency.  Most currency pairs consist of five significant digits and most pairs have the decimal point after the first digit, e.g. EUR/USD equals 1.2812.  In this case, a single pip increase would be a pip increase to EUR/USD 1.2813.  A single pip decrease would be a pip decrease to EUR/USD 1.2811.

So, for example, when a the EUR/USD quote is increasing from 1.300 to 1.400, the EUR is strengthening – it previously could only buy 1.300 USD and now it can buy 1.400 USD.  The reverse is also true.  When the quote is decreasing, the first currency in the pair, the base currency, is weakening. So, for example, while the EUR could previously buy 1.300 USD, now it can only buy 1.200 USD.  In this case, it has weakened.

(be sure to scroll through additional pages below)


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Trade Like a Hedge Fund, by James Altucher

November 28th, 2008
Trade Like a Hedge Fund James Altucher

Trade Like a Hedge Fund James Altucher

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Trade Like a Hedge Fund: 20 Successful Uncorrelated Strategies & Techniques to Winning Profits
by James Altucher
Published in 2004

Key Takeaways
In this post I summarize what I believe are the key takeaways of the book. If you like what you see, I encourage you to buy the book.  The book is a technicians guide with several different systems for buying low, selling high.  Mr. Altucher primarily employs counter trend strategies.  The book illustrates how a professional hedge fund manager thinks about the markets to take advantage of irrational ‘breakouts’ and ‘breakdowns’.  There is a lot of data, but the book is not overly technical in any respect.  The book has some great ideas to take with you when you trade, but I wouldn’t follow them blindly.  For example, I felt his stance on risk management was a little weak, often suggesting you should hold on to losing positions longer than I think wise.

Page 15 – Swing Trading the Gap

  1. Buy a stock when the stock is down the day before, AND your chosen reference index (e.g. S&P500 or Nasdaq) is gapping down more than 0.5 percent, AND the stock is gapping down more than 5 percent
  2. Hold the stock at least until the next morning
  3. Sell the stock when the stock goes lower than the prior day’s close.  Not to be confusing, note, this means you could hold the stock for several days, as long as it keeps opening higher each successive day.
  4. Cut any loss at 3 percent

Stock CIEN closed at 51.51 on April 16, 2001  The next day, April 17, 2001, it gapped down to 48.11 when we bought it.  It then reversed that same day and closed at 53.09.  The stock then gapped up on April 18, 2001 and kept gapping up at the open for two ore days before finally stalling on April 20, 2001.  Since it opened that day lower than the close the day before at 67.30, the trade was stopped out at the open at 67.09 for a 38.22 percent profit.

CIEN 4-17-011

CIEN 4-17-011

Basically, this is saying buy a stock when the stock AND the market are oversold.  At the very least, down the day before, then gapping down sharply the next day.  Then sell it when the stock starts to stall.  Obviously this strategy doesn’t work every time.  But his book shows that executing this trade 500 times on NASDAQ stocks (using a bit of leverage) during 2001 yielded 373 percent annual return.

(be sure to scroll through the additional pages below)


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