Recently, I read a book by George Soros titled “The Crash of 2008 And What It Means”. Overall, it is an overly lengthy book because the entire book is basically talking about one theory; Reflexivity. However, it is intriguing and hence I would like to share it here.
The argument is that humans base their decisions not on the actual situation but their perception of that situation. And these decisions impact the situation leading to (further) changes in the perception of the situation.
In the context of economics:
“Reflexivity asserts that prices do in fact influence the fundamentals and that these newly influenced set of fundamentals then proceed to change expectations, thus influencing prices; the process continues in a self-reinforcing pattern. Because the pattern is self-reinforcing, markets tend towards disequilibrium. Sooner or later they reach a point where the sentiment is reversed and negative expectations become self-reinforcing in the downward direction, thereby explaining the familiar pattern of boom and bust cycles.” - Wikipedia
It is widely deemed that fundamentals should determine price (at least in the long term) but this theory is arguing that fundamentals is influenced by price hence leading to an “incorrect” fundamentals (at least some of the time).
My interpretation is as follows:
Fundamentals should not be taken as ground truth. Even if it is not accounting fraud, it can/will be tainted with sentiments/expectations.
Technical/Sentimental analysis should not be completely ignored.
What is your interpretation of it and how would/have this theory change your investment approach?
Hmm, yea I do agree with it. Price definitely plays a big influence in the way we view a company. A company with rapidly falling price tends to be perceive as doing a lot worse than it is. As such, it exacerbates the sell-off and leads to over correction.
Perhaps, one way to deal with this issue, is to deal with the fundamental side of the company without looking at the price/daily movement. This will remove the prejudice that we have against the stock.
In the long run however, I feel that fundamentals will wash away the sentiments created by the price movement.
My takeaway from this is - the market is not always efficient. They tend to be; but at times of pessimism/optimism, they might behave irrationality for a short period before gaining efficiency again.
My two cents worth. (: Still have a long long way to learn about investing.
“one way to deal with this issue, is to deal with the fundamental side of the company without looking at the price/daily movement.”
I assume when you say the fundamental side of company as in what are its competitive advantages and how good the managements are etc? Since the accounting numbers would be influenced by sentiments, according to this theory.
“My takeaway from this is - the market is not always efficient. They tend to be; but at times of pessimism/optimism, they might behave irrationality for a short period before gaining efficiency again.”
This kinda suggests to me that maybe we should have three different investing strategies depending on the state of the market (i.e. Optimistic state, pessimistic state and neutral state.)
What I meant was to look purely at accounting numbers or more specifically, the balance sheet. Numbers don’t lie but management do! It is also tough to determine if there is true competitive advantage for the company and sentiments do affect how we perceive the company. Hmmm, nice catch there on the second comment. However it is difficult for most retail investors to do so. Too much effort will be required. I would rather focus on one of the three phase and capitalise on it when mispricings occur.
“What I meant was to look purely at accounting numbers or more specifically, the balance sheet. Numbers don’t lie but management do!”
Hmm… that is what the theory is claiming though. It is saying that accounting numbers cannot be trusted because it is influenced by price/sentiment For example, assets valuations would be higher during times of optimism. I think in the book, it gave an example of 2008 subprime problem where the housing valuation increased leading to easier loans and easier loans lead to even higher housing valuation and the cycle continues until it can no longer be sustained then burst
Arh I see. I have a slightly interpretation on that statement that’s why. Haha. I was thinking about it mostly in the context of stock valuation. For example, I would always buy a company below its conservative book value and within a certain normalised PE ratio. This prevents me from overpaying for a stock because it is rising in price and seems to have a good prospect. However, I do see the point that Soros is trying to bring up. It is very true.
Sometimes, I am surprised by financial analysts who can change their opinion of the target price of a stock so quickly and often mirroring something close to the actual trading price
For example, assets valuations would be higher during times of optimism. I think in the book, it gave an example of 2008 subprime problem where the housing valuation increased leading to easier loans and easier loans lead to even higher housing valuation and the cycle continues until it can no longer be sustained then burst 
