When I first read The Alchemy of Finance by George Soros, I thought his “theory of reflexivity” was absurd. It seemed to be an ex post facto explanation for his investment success. Now, having spent more time in the financial markets, I believe he was correct in his observations. We live in a world in which the markets do not stand still.
It is important to recognize that the idea of reflexivity does not stand on its own. As Soros states:
“The two principles [fallibility and reflexivity] are tied together like Siamese twins, but fallibility is the firstborn: without fallibility there would be no reflexivity.”
What does Soros mean by fallibility?
“My conceptual framework is built on two relatively simple propositions. The first is that in situations that have thinking participants, the participants’ views of the world never perfectly correspond to the actual state of affairs. People can gain knowledge of individual facts, but when it comes to formulating theories or forming an overall view, their perspective is bound to be either biased or inconsistent or both. That is the principle of fallibility.”
Soros lays out the argument that behavioral economists would be making for the next three decades: We humans are not perfectly rational decision makers. Instead, we are prone to all manner of information gathering and analytical biases.
Where things get interesting is when these biases have an effect on the markets. Not only will markets do some really strange things, like produce the dot-com bubble, but these beliefs change our behaviors forever.
“The second proposition is that these imperfect views can influence the situation to which they relate through the actions of the participants. For example, if investors believe that markets are efficient then that belief will change the way they invest, which in turn will change the nature of the markets in which they are participating (though not necessarily making them more efficient). That is the principle of reflexivity.”
The idea of reflexivity is a difficult one for academic economists and their adherents because by its nature, reflexivity is difficult, if not impossible, to model. According to Soros:
“My conceptual framework deserves attention not because it constitutes a new discovery, but because something as commonsensical as reflexivity has been so studiously ignored by economists. The field of economics has gone to great lengths to eliminate the uncertainty associated with reflexivity in order to formulate universally valid laws similar to Newtonian physics.”
This is why the financial market is so challenging for participants and academics alike. It is always changing. Unlike philosophy, where students can go to the teachings of Plato and Aristotle, there is no such canon for investors to access. Take a moment to think how financial markets have changed in the past century. The continuous, hyper-connected global markets of today would be nearly unrecognizable to traders back in the early 1900s.
Over long periods of time, what seem like bedrock market principles can be overturned. For example, until the 1950s common knowledge held that equity dividends should exceed the yield on government bonds. This relationship flipped around for another half century or so while Treasury yields exceeded that of the S&P 500. In the wake of the global financial crisis and quantitative easing (QE), this relationship flipped once again.
The financial markets are becoming ever more efficient at upending previous market relationships. Today, analysts rely on charts indicating the correlation between two or more financial variables to make some sort of market pronouncement. Unfortunately, correlations change. Josh Brown writes:
“Correlations don’t last forever, and there’s no one setting the timer. One of the biggest mistakes we can make as investors is to assume otherwise.”
Some, like Jeremy Grantham, argue that the US Federal Reserve and other central banks have changed the way the game is played through the application of QE. Grantham recently observed that the death of the presidential election cycle was killed in part due to the Fed:
“The presidential cycle owed everything to the Fed. The Federal Reserve, completely innocently, always decided to come to the aid of the party in power. . . .They [the Fed] are constantly looking for excuses to push down on interest rates and drive asset prices higher to get some wealth effect. I don’t trust them any more to play the easy presidential cycle.”
This is similar to the idea of the observer effect in physics where the act of observation changes the phenomenon being observed. This can also be seen in the effect that published academic research has on so-called market anomalies. Larry Swedroe summarized recent academic papers that demonstrated how publicized anomalies induce trading by institutional investors and thereby degrade the magnitude of the anomaly.
Why these anomalies don’t disappear entirely is due in part to the limits of arbitrage. It will be interesting to see how these effects play out over time in the smart beta space. The domestic exchange-traded fund (ETF) market is now awash in various smart beta strategies. We are seeing a real-time horse race between the durability of these effects and market participants. Only the most robust factors will continue to see risk-adjusted returns over time.
Reflexivity is reflected in how cash flows into certain asset classes have changed the underlying returns of that asset class. For example, private equity funds have seen massive global growth in the number of funds and the assets they manage. Unfortunately, investors who have chased this wave have seen disappointing returns.
The same phenomenon occurred in the hedge fund industry. Hedge funds emerged from the dot-com boom with a halo. Returns were robust and they avoided the worst of the drawdown affecting other asset managers. However, the decades long boom in the hedge fund industry has left it overcrowded and unable to generate competitive returns. Larry Fink, chairman and CEO of BlackRock, stated:
“The hedge fund community has had reduced and in some cases negative returns, and with high fees you are seeing a re-evaluation of how you’re going to allocate your money.”
This just affirms that we live in an era of constant, rapid change. Static portfolio allocations seem as foreign today as the internet did 25 years ago.
Eternal market truths are hard to find and difficult for us fallible humans to understand. In the end, this highlights the importance of ongoing education and research efforts, as well as the responsibility of analysts to focus on their continuing education.