From the FT’s review of George Soros’ latest book:
In markets, Soros says, participants’ thinking plays a dual function: they try to understand the situation (the "cognitive function"), and to change it (the "manipulative function"). The two functions can interfere with each other; when they do so the market displays "reflexivity".
So an investor’s misperception of reality can help to change that reality, begetting further misperceptions. When market actors’ decisions affect outcomes, patterns emerge. If a lot of people are bullish about internet stocks their price goes up. Soros used the theory to predict, and profit from, a series of "initially self-reinforcing but eventually self-defeating boom-bust processes, or bubbles". Each bubble "consists of a trend and a misconception that interact in a reflexive manner".
A key implication of this is that markets do not tend towards "equilibrium", as predicted by modern portfolio theory. And they will not move in the "random walk" promulgated by efficient markets theory, which holds that prices always incorporate all known information and so move randomly in response to new information.
This is important, as the architecture of modern capital markets depends on these theories. And it begins to look as though the credit crisis was the tipping point at which academics and practitioners decided a new paradigm was needed to replace the efficient markets hypothesis. Alternative theories borrow from experimental psychology, advanced mathematics and evolutionary biology and have been built in response to experience in the markets.
The theory of "adaptive markets" – that markets follow trends until they become overblown and then start building up other trends – seems to be gaining ground as an alternative paradigm.