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?