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.
Dear Ben,
I’ve been a pretty consistent fan of your writing for a couple of months now. You integrate such a broad spectrum of topics into your worldview, a skill much needed in the reality Soros describes. Kudos to you.
During my time at Juniata College, a small liberal arts, in central Pennsylvania, I had the “privilege” of taking some courses in cultural analysis, particularly in postmodernism, and some exposure to chaos theory and epigenetics. The courses were difficult and challenging, and team taught by faculty from different departments. It seems our beaurocratic structures and our tools to describe and analyze those structures are all from a modern era, that is trying to gain truth in this postmodern world. In a postmodern world, left can be right, right can be left, and no matter which side of the picture you are on, you are indeed correct because Truth has ceased to exist. When yo ubeing examining social structures in this light (a viewpoint that is more “felt” than it is learned by reading a simple synopsis), it really opens your worldview considerably. You realize that your worldview is precedented on the lens from which your looking out and in the end we all have fractions of the Truth and base further understanding based on false truths. This is the problem behind reductionist thinking in complex thinking. Why Heisenburg’s Uncertainty Principle pulled the rug out of traditional science, and is the basis for the economic structures now at play with a flattened world. If you look at nutrigenomics, “modern” physics, social netoworking venues like facebook and myspace. They ahve been successful because they are modeling around known uncertainty in a system and giving people a sense of order in that system that we all (with our modern mindsets) seek.
I didn’t have much time to flesh this out like I wanted but I would love for you to filter through some of these ideas and give some of your own insights on how entrepreneurs can profit from a postmodern world. Soros just might have given the summary we’ve all needed to begin profitting from these phenomena….
Anyone who is active in the stock markets can vouch that when there are millions of mindsets at work, each one interpreting available information in one way or other, having no common perception. All that they have is millions of perceptions, one countering the other and that makes the market, yielding a buyer for every seller and vice versa.
If the markets were ever “efficient” – all information being fully priced into the stock at given point in time – the singularity of perception will lead to a jam when everyone will only buy or will only sell; offering no scope for actual transactions to take place.
As far as the credit crisis goes, too much of paradigm shifts did them in. It’s the logical outcome when common sense gives way to far too much algebraic modelling and algorithms replace old fashioned norms of commercial lending and risk management practices(lending to those who can’t buy a decent meal and then selling the CLOs to Wall Street Banks that eventually collapse under its weight).
Alex – thanks for the comment. “Postmodern” is a term that has many meanings in different contexts. I will try to address some of the points you raise in the future…
Ben, don’t you think that theory reminds somehow to product adoption curve in tech markets?
inverstors with soro’s phylosophy invest when the “chasm” has been crossed and the trend is forming (early adopters large base get into the “trend”)
once the trend/bubble grows big, after the late-early majority, early-latemajority, and befford laggards (trend followers) get into the market) it is probably the moment to de-invest and cash-out.