BACKGROUND TO GEORGE SOROS’S MARKET PHILOSOPHY

George Soros’s life in short can be summarized as ‘the story of the failed philosopher who turned out to the one of the biggest macro trader of all times.’ This article tries to delve deeper into the situations and circumstances that he experienced throughout life that led to the shaping of his trading philosophy.

Early learning

George Soros stresses the importance which his father played early on his life, according to him ‘the formative experience of my life was the German occupation of Hungary in 1994, at the time I was about 14 years old. Fortunately, my father was well prepared for this as he had fought in the First Word War and lived through the Russian Revolution. So when the Germans occupied Hungary my father immediately realized that these were not normal times and arranged false identities for his family and also for a number of other people. Surviving the ordeal with the help of my father made me feel very special. After the Nazis and the soviets occupation life in Hungary started to lose its luster, and with the help of my father I found my way out of the country, and was in London, enrolled as a student in London School of Economics.’ George Soros immigrated to England in 1947 and as an improvised student, lived with his uncle; an orthodox Jew, who paid d his living expenses while he attended studies.

Developing his theory

During his studies at London Soros’s primary interest was to gain ‘a better understanding of the strange world into which he had been born’ and emphasized the help which Carl Popper provided ‘I started developing my philosophy as  a student at the London School of Economics in the late 1950s. As I had a year to fill before I was qualified to receive my degree, I could choose my own tutor and I chose Carl Popper, whose book, The Open Society and its Enemies, had made a profound impression on me. In his book Popper argued, that the empirical truth cannot be known with certainty, even scientific laws can’t be verified beyond a shadow of doubt – they can only be falsified by testing; one failed test is enough to falsify, but no amount of confirming it is sufficient to verify it.  Popper proposed a more attractive form of social organization, an open society in which people are free to hold divergent opinions and the rule of law allows people with different views and different interest to live together in peace. I found the idea of an open society immensely attractive. While I was reading Popper I was also studying economic theory, and was stuck by the contradiction between Carl Popper’s emphasis on imperfect understanding and the theory of perfect competition in economics which postulates perfect knowledge – this led me to start questioning the assumption of economic theory.’  

First serious foray into philosophy

Soros believed that having lived both the Nazis and the Communist occupation gave him a special insight that had prepared him well to become an important philosopher ‘I had to confess that I harbored some fantasy of becoming an important philosopher, I believed that I had gained insight that set me apart from other people. Living in London was a big letdown as people were not interested in what I had to say, but I did not abandon my philosophical ambition, and after completing my studies, I ended up as an arbitrage trader in New York. In my free time I continued to work on my philosophy, and that’s how I came to write my first major essay titled, The Burden of Consciousness, it was an attempt to model Popper’s frame work of open and close societies: it linked organic societies with a traditional model of thinking, closed society with a dogmatic model of thinking and open societies with a critical mode of thinking. What I could not properly resolve was – the nature of the relationship between the mode of thinking and the actual state of affairs, that problem continued to preoccupy me and that are how I came to develop the concept of reflexivity which provided me with the new way of looking at financial markets. This gave me confidence and I felt that I was in possession of a major discovery that would enable me to fulfill my fantasy of becoming an important philosopher. At a certain moment when my business career ran into a roadblock, I devoted all my energies to develop my theory. And, as I delved deeper and deeper into the subject I got lost in the intricacies of my own construction. One morning I couldn’t understand what I had written the night before, and at that point I decided to abandon my philosophical exploration and to focus on making money.’ After that George Soros continued to put his philosophical pursuits on the back burner and returned many years later when he published his first book ‘The Alchemy of Finance’ in 1987, in that book Soros tried to explain the philosophical underpinnings of his approach to financial market.

Theory of reflexivity

Soros sees that instead of recognizing the importance of reflexivity economists have pushed it back or even worse avoided it as if it does not exist. He explains the theory as ‘I can state the core idea of my theory in two relatively simple proposition, one, that the situation that has thinking participants; thinking participants view of the world is always partial and distorted – that is the principle of fallibility, and the second, that these distorted views can influence the situation to which they relate because false views lead to inappropriate actions – that is the principle of reflexivity.’ Soros adds ‘the participants thinking serve two functions: one is to understand the world we live in – the cognitive function, and the second, is to change the situation to our own advantage – manipulating or the participating function. The two functions connect the thinking and the reality in opposite direction, in the cognitive function reality is supposed to determine participants view, the direction of causation is from the world to the mind. And in the manipulating function the direction of causation is from the mind to the world, i.e. that the intention of the participants has an effect on the world, when both functions operate at the same time they can interfere with each other, by depriving each  function of the independent variable that would be needed to determine the value of the dependent variable, because when the independent variable of one function is dependent variable of the other, neither function has a independent variable, this means the cognitive function cannot produce enough knowledge to serve as the basis for the participants decision. Similarly, the manipulative function has an effect on the outcome, but can’t determine it, in other words the outcome is liable to diverge from the participants intentions. There is bound to be some slippage between intentions and actions, and further slippage between actions and outcomes. As a result there is an element of uncertainty both in our understating of reality and in the actual course of events. The participants thinking find expression in various forms of actions and behaviors that takes the form of feedback loops. And the feedback loop can be either positive or negative: negative feedback loop brings the participants views and the actual situation closer together, and positive feedback loop drives them further apart. In other words, negative feedback is self correcting; it can go on forever and if there are no significant changes in external reality it may eventually lead to equilibrium where the participant’s views come to correspond to the actual state of affairs. That is, what suppose to happen in financial market so equilibrium which is a central case in economics turns out to be a limiting case in my conceptual framework? By contrast a positive process is self reinforcing, it can’t go on forever because eventually the participants views would become so far removed from objective reality that the participants would have to recognize them as unrealistic, the reason is that it is in the nature of positive feedback that it reinforces whatever tendency prevails in the real world, instead of equilibrium we are faced with a dynamic dis-equilibrium or far from equilibrium condition. Usually in far from equilibrium situations the divergence between perception and reality leads to a climax which sets in motion positive feedback process in the opposite direction, such initially reinforcing but eventually self defeating boom bust process or bubbles are characteristic of financial markets.’ To better explain his theory of reflexivity Soros further clarify his boom bust along the line of feedback loops ‘every bubble has two components, an underlying trend that prevails in reality and a misconception relating to that trend. A boom bust process is in motion when a trend and misconception positively reinforces each other, the process is liable to be tested by negative feedback along the way, if the trend is strong enough to survive the test both the trend and the misconception will be further reinforced eventually market expectation becomes so far removed from reality that people are forced to recognize that a misconception is involved. A twilight period ensues during which market grow and more people lose faith but the prevailing trend is sustained by inertia. Eventually, a point is reached where the trend is reversed it then becomes self reinforcing in the opposite direction. The length and strength of each stage is unpredictable but there is an internal logic in the sequence of stages, so the sequence is predictable but even that can be terminated by government or some other form of negative feedback. Typically, bubbles have an asymmetric shape, the boom is long and drawn out, slow to start, it accelerates gradually until it flattens out during the twilight period, the bust is short and steep because it is reinforced by the forced liquidation.’ According to George Soros the number one reason why bubbles happen ‘the trend is when credit becomes cheap and more easily available activity picks up and values rise, there are fewer defaults, credit performance improves and lending standard are relaxed, so at the height of the boom the amount of credit involved is at its maximum and reversal precipitates forced liquidation and depressing prices.’

Learning for the common trader

Soros believed that ‘most of the time we are punished if we go against the trend, only at inflection point are we rewarded’ meaning – we can never really know for sure what is going to happen in the market, so we must trade in time with the fact, otherwise we will get too emotional about our trade and we will start thinking that we have some special gift for predicting the market. And he like any great trader also believed that making money at the stock market was hard work ‘if investing is entertainment, if you are having fun, you are probably not making any money. Good investing is boring.’ George Soros will probably be remembered as the speculator who slanted against the Bank of England in 1992 resulting in a billion dollar pay day, as he had no illusion for his unprecedented track record at the stock market ‘I basically have survived by recognizing my mistakes.’     

Words of wisdom

George Soros’s sole objective of developing the theory of reflexivity was not only to make money, he said that ‘the frame work that helped me make money first as a successful hedge fund manager and then spending it as a policy oriented philanthropist was never about money, but was about the relationship between thinking and reality.’ 

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