George Soros - Reflexivity Explained

hello and welcome back to patrick boyle on finance in today's video we're going to discuss george soros and his theory of reflexivity we'll try to understand what it means how he uses the idea to make money his criticisms of traditional economics and we'll look at some examples of reflexivity in action in addition i'm going to provide links to the books that i found most useful on this topic in the description below do stay tuned until the end of the video where i'll tell you how to win a copy of my book derivatives for the trading floor [Music] so george soros is possibly the most famous hedge fund manager in the world he's best known as the man who broke the bank of england due to his famous 1992 trade where he sold 10 billion dollars worth of british pounds short earning him a one-day profit of a billion dollars in the 1992 british currency crisis and as a friend of mine always likes to point out to me that was back when a billion dollars was a lot of money based on his early studies of philosophy soros formulated what he calls his general theory of reflexivity for capital markets which he claims renders a clear picture of asset bubbles and market behavior over the course of his career he's written 15 books and his writings focus very heavily on this concept of reflexivity the book that i feel best explains the overall concept is called the credit crisis of 2008 and what it means and i'll link to that in the video description below it was written as the financial crisis was unfolding back in early 2008 and the entity explains his theory of reflexivity and how it was affecting the market real time to this day i think that it's the best book on the credit crunch even though it was written over six months before the lehman brothers bankruptcy there are two cardinal principles to sources theory as it applies to financial markets first that market prices distort the underlying fundamentals and second that financial markets have an active role often affecting the fundamentals that they're supposed to simply reflect these ideas contradict the efficient markets hypothesis which says that market prices accurately reflect all of the available information soros argues that while behavioral economics is a step in the right direction it too is flawed as it focuses only on one half of a reflexive process the mispricing of financial assets and it doesn't concern itself with the impact of the mispricing on changing the fundamentals so what exactly is reflexivity well to a certain extent we can think of reflexivity as a feedback loop soros claims in his writing that there are two types of reflexive feedback loop that characterize financial markets negative and positive negative feedback he argues is self-correcting while positive feedback is self-reinforcing negative feedback sets up a tendency towards equilibrium while positive feedback produces dynamic disequilibrium to soros positive feedback loops are much more interesting as these can cause big moves both in market prices and importantly in the underlying fundamentals a positive feedback process that runs its full course is initially self-reinforcing but eventually it's liable to reach a climax or reversal point after which it becomes self-reinforcing in the opposite direction he notes that positive feedback processes do not necessarily always run their full course they may be aborted at any time by intervention or negative feedback so as an example of negative feedback loops we can think about something like oil prices when oil prices got very high a bit over a decade ago people rushed out to buy fuel-efficient cars like the toyota prius they possibly turned down their central heating at home they took fewer flights as flights had become more expensive the high price also would have incentivized oil companies to invest in things like fracking and offshore drilling which increased the supply of oil this combination of greater supply and lower demand brought oil prices back down today with low oil prices the opposite is happening with people buying ford raptors and dodge hellcats and oil companies cutting production this negative feedback loop can be seen as a stabilizing force causing certain commodities to mean revert over time now as an example of a positive feedback reflects a process we can use amazon.com amazon benefited from the over-exuberance of market participants in the late 1990s where huge amounts of capital were allocated to dot com stocks jeff bezos was an incredibly capable manager and used this almost unlimited free capital to grow his business as the business grew it attracted more cheap capital and it was then able to grow even more every other retailer whether online or not was required to show earnings to their investors they had to sell goods at a profit but at amazon they were able to burn capital as long as they showed growth thus amazon was able to be extremely aggressive with pricing which drove competitors out of business and brought about even more growth now in 2006 amazon launched aws the cloud infrastructure as a service arm of amazon with no fanfare as a small side business 10 years later this was the most profitable part of amazon without positive reflexivity amazon's core original business could not have grown the way it did and then due to jeff bezos's pivot into a diverse non-retail related business no bust cycle occurred the original investors in amazon obviously could not have predicted this outcome they possibly hoped that amazon would simply become the biggest bookseller in the world amazon's success is due to a combination of great management and a self-reinforcing feedback loop which gave jeff bezos this amazing opportunity today we see stocks like tesla on a similar trajectory the plain bagel youtube channel put up a great video yesterday on the valuation of tesla which i'll link to in the description below at this point in time there's no way of knowing if elon musk will find an aws equivalent a cash cow kind of business line or if he'll have to rely on high volume car sales to justify the stock price in the long run so amazon is an example of a positive reflexive feedback loop taking place with no eventual bust occurring and this is something that can happen under sources reflexivity framework soros argues that every bubble has two key components an underlying trend that prevails in reality and the misconception relating to that trend a boom bust process is set in motion when the trend and the misconception positively reinforce each other the process is liable to be tested along the way by negative feedback from time to time if the reflexive loop is strong enough to survive the test both the trend and the misconception will be further reinforced eventually market expectations become so far removed from reality that people are forced to recognize that a misconception is involved when this happens a twilight period occurs during which doubts grow and more people lose faith but the prevailing trend can still be sustained by inertia eventually a point is reached where the trend is reversed and once it does it then reverses and self-reinforces in the opposite direction soros argues that bubbles typically have an asymmetric shape that the boom is long and drawn out it's often slow to start then accelerates gradually until it flattens out during the twilight period the bust is short and steep because it's reinforced by the forced liquidation of leveraged positions disillusionment turns into panic reaching its climax in a financial crisis he argues that the length and strength of each stage is unpredictable but there is an internal logic to the sequence of the stages much like the amazon example the entire sequence need not complete as the cycle can be terminated by some type of intervention or some sort of negative feedback along the way the example that source highlights in his 2008 book is a real estate boom he argues that this is the simplest case of a boom bus cycle in a real estate boom the initial trend is that credit becomes cheaper and more easily available the misconception that turns the trend into a bubble is the false idea that the value of real estate is unrelated to the availability of credit as the underlying real estate becomes more valuable owners of real estate become more creditworthy and can borrow more based upon their holdings being used as collateral for loans the relationship between the availability of credit and the value of the collateral is reflexive when credit becomes cheaper and more easily available economic activity picks up and real estate values rise there are fewer defaults credit performance improves and lending standards are relaxed at the height of the boom the amount of credit involved is at its maximum and a reversal precipitates forced liquidation depressing real estate values he points out in the book that almost all loans are collateralized with real estate it's the asset that banks are the most willing to lend against due to its perceived stability and thus real estate and property landing is a major contributor to boom boss cycles soros is quite clear that from a speculator's perspective an inflating bubble is not an opportunity to go short when he sees a bubble inflating he rushes in to buy adding fuel to the fire but being prepared to reverse his position when the market turns he argues that this is the rational thing for a speculator to do and thus regulators are needed to counteract the market when a bubble is threatening to grow too big he says that in this type of situation we can't rely on market participants however well-informed and rational they might be soros describes the interaction between market participants and financial authorities as an important and interesting reflexive interaction he points out that the occasional financial crisis leads to regulatory reforms which can have reflexive properties both regulators and market participants act on the basis of imperfect understanding and that makes the interaction between them reflects it soros initially claimed that his ideas were dismissed by academia because academics were too stuck in their ways and too tied up with financial mathematics it's worth noting however that his ideas are becoming increasingly discussed by mainstream economics right now i'm reading radical uncertainty by john k and mervyn king mervin king is the former governor of the bank of england the idea of reflexivity comes up quite a lot in the book and the authors discuss the idea that reflexivity undermines stationarity in econometrics they point out that good hearts law an adage named after the british central banker charles goodhart is almost a description of reflexivity goodheart's law is usually stated as when a measure becomes a target it ceases to be a good measure the idea being that once market participants start focusing on a given factor or indicator it loses its usefulness in his writing source argues in favor of greater intervention by central bankers and regulators in markets in order to maintain stability as a counterpoint though it could be argued that if market participants with their money on the line and skin in the game cannot recognize bubbles how can government-appointed regulators be expected to do so constant interventions by regulators adjusting margin requirements restricting the sale of new securities and instructing banks on which sectors they should lend to could possibly cause more harm than good in the way that well-meaning government price fixing always seems to cause problems such as with rent control or capping the price of foods it's not clear to me that regulators should get involved in this type of intervention it's worth noting though that such intervention is common in countries like china for example i would add that while boom and bust cycles do transfer wealth from those who've invested foolishly to those who invest wisely it's not obvious to me that this is such a bad thing an example would be the railway mania in britain in the 1840s where at the end britain was left with a vast expansion of the railway system this expansion might never have occurred without the speculative bubble similarly the dot-com bubble led to a huge internet infrastructure being put in place in the late 1990s that we continue to benefit from today let me know in the comments section below of any really good examples of reflexivity that you can think of in the markets i'll send a free copy of my financial derivatives book that's called derivatives for the trading floor to whoever writes the best comment and who is also a subscriber to the channel i'll go through the comments to select the winner when the video gets 5 000 likes this is my last video of 2020 so let me wish all of you guys a happy new year talk to you later bye i did it in order to make a profit sure and to expect market participants to to be concerned about the social consequences of direction is putting the emphasis in the wrong

Channel: Patrick Boyle

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Keywords: finance, trading, patrick boyle, on finance, kings college london, business school, quantitative finance, financial derivatives, personal finance, investing, investments, George Soros Reflexivity Explained, george soros, hedge funds, trading style, reflexivity, economics, macro trading, macro investing, man who broke the bank of england, fx trading, foreign exchange, currency, hedge fund, greatest trader, tesla, plain bagel, amazon, tsla, amzn, trend following, trend, mervyn king

Id: zX1nm6PoI-g

Length: 15min 12sec (912 seconds)

Published: Tue Dec 29 2020