What is George Soros’ Theory of Reflexivity?
“I am not concerned with forecasting what will happen, but with understanding the reflexive interaction between perception and reality.” — George Soros
George Soros is one of the greatest financial traders in history. After surviving the Nazi occupation in Hungary, Soros studied at the London School of Economics before moving to New York and becoming a Wall Street legend.
Today, he’s worth over $7 billion. However, Soros is no ordinary trader — he’s also a philosopher, due in part to the influence of studying under Karl Popper at LSE.
In this piece, we’re going to take a look at what Soros’ Theory of Reflexivity is and how he has used it as a trader.
Foundations of the Theory of Reflexivity
To understand the Theory of Reflexivity, we first need to look at who Karl Popper was and what he taught George Soros.
Popper was a philosopher of science. When Soros studied at LSE, he was teaching philosophy with a particular focus on the philosophy of science, epistemology, and political theory.
Popper taught Soros his concept of falsifiability — that scientific theories can never be proven true, only false. This idea led to Popper’s promotion of Open Societies, where no idea or regime claims ultimate truth and where people are free to challenge and improve upon ideas and institutions.
Popper’s concept of falsifiability and the ultimate uncertainty of all knowledge deeply affected Soros. It led to him thinking about how biases can affect our thinking, and he realized that since markets are made up of people, those biases could ultimately affect markets.
Soros’ Theory of Reflexivity in a Nutshell
“I contend that financial markets do not tend toward equilibrium; they are crisis-prone. Reflexivity introduces instability.” — George Soros
Working as a gold trader in London, Soros began to apply Popper’s ideas to markets. He developed his General Theory of Reflexivity — that biases and perceptions can affect market prices and that those prices can in turn affect perceptions, creating a two-way feedback loop.
In short, if market participants believe the price of a given asset is likely to rise, they may buy. The buying increases the price of the asset, causing it to rise, causing the market participants to believe they were correct and potentially buy more in anticipation that it will rise further.
That’s the abstract theory, but we can look to several concrete examples:
- Every crypto cycle plays out like this. Traders expect BTC to rise after a halving, so they buy, causing it to rise, which confirms their initial perception that it would, causing others to jump on the bandwagon, causing it to rise further, etc.
- The dotcom bubble is another example. People believed worthless companies were going to be the next big thing, so they bought, causing the prices to rise, which caused them to believe they were right, so they bought more, reinforcing the perception that these companies had value even further.
Soros was a critic of market rationality. He simply didn’t buy that prices reflect fundamentals, buyers and sellers are rational, or that markets correct themselves over time. To him, it seemed obvious that markets are irrational, buyers and sellers act on biased perceptions, and that their actions impact the very fundamentals they are trying to assess.
It’s highly likely that we’re in another such reflexive loop today. People believe AI will revolutionize everything, so they’re pouring money into companies like Nvidia and Palantir, thus driving up their valuations, and ultimately confirming the initial belief that these companies are the next big thing.
The problem is that these cycles are sometimes stable, but very often unstable, as Soros hinted at in the quote at the beginning of this section.
How Soros Used the Theory of Reflexivity to Break the Bank of England
The Theory of Reflexivity isn’t just an abstract idea Soros penned in some book or journal. He has applied it in his career as a trader and has made billions from it.
Soros is known as The Man Who Broke the Bank of England due to his most famous trade. On Black Wednesday (1992) he made approximately $1 billion shorting the British pound.
Before the euro, European countries used the Exchange Rate Mechanism (ERM) to keep their currencies pegged. Soros believed it would be difficult for the BoE to keep the pound pegged to the Deutsche Mark due to various factors like high inflation and weak growth.
So, he put a huge short position against the GBP. Soros and other traders put downward pressure on the pound, forcing the BoE to raise rates to defend it. However, the more they did, the more fragile and irrational the situation seemed, which spooked the market and caused further downward pressure on the pound. This ended with the UK leaving the ERM, the pound crashing, and Soros making a tidy $1 billion profit for his fund.
The reflexivity loop is clear: Negative sentiment led to downward pressure which led to real policy failure which led to more downward pressure until the cycle was complete.
This isn’t the only time Soros has used his theory of reflexivity to net handsome profits. He also went short on the Thai Baht during the Asian Financial Crisis in 1997, made more than $2 billion shorting the tech bubble in 2000, and it’s well-known that he has been long the Chinese Yuan since the mid-2000s.
So, that’s George Soros’ Theory of Reflexivity explained. What do you think about it? Have you ever made a trade based on it? If so, how did that turn out?
