Today, I read George Soros’ essay on the General Theory of Reflexivity. It’s a fascinating essay and opened up a philosophical side to Soros to which I was previously unaware! I immediately added his famous book, The Alchemy of Finance, to my reading list.
He clearly spent years refining his philosophy and understanding of the world, and has used this philosophy to guide his decision making and investing. The essay is a great reminder of the importance of having a philosophy to help navigate the world, decisions, and of course, maneuvering financial markets.
I want to first point you to reading his essay before this post. The following article includes a collection of my notes in the margins of the essay, and allow me to better understand his ideas as I work through them. I don’t have much to add, but rather see writing as a way to better digest his ideas.
General Theory of Reflexivity
One thing I found interesting about his essay is that it’s not about money. Instead, “it is about the relationship between thinking and reality.” Or, as he states later, between the mode of thinking and the actual state of affairs.
As you read, you begin to understand how these two mesh together, and the cause and effect dynamics between thinking and reality. Sure, understanding these ideas philosophically will certainly turn to the realm of money. But first, start with the ideas.
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 conforming instances is sufficient to verify.
This reminded me of Nassim Taleb’s idea of the turkey in The Black Swan. Allow me to butcher his idea: imagine you have a turkey. Every day, you observe that the turkey is happily living and going about its day. You begin to conclude that the Turkey lives an unaffected life and should live until old age.
Even worse, with each passing day, your confidence in your conclusion grows stronger. But, the day before Thanksgiving, the Turkey is taken outside and killed.
There are a few important and relevant bits in this example.
With each passing day, your confidence grew higher. But, ironically, your confidence was highest at the time when you were most incorrect in your conclusion (immediately before Thanksgiving)!
This dynamic between our conclusions and confidence levels exists every day in the financial markets. Look to any asset bubble or trough
No amount of conforming evidence can support the truth 100%. It only takes one falsifiable event, the day before Thanksgiving, to prove our conclusion wrong
I was struck by the contradiction between Popper’s emphasis on imperfect understanding and the theory of perfect competition in economics which postulated perfect knowledge.
Knowing that knowledge is never complete and 100% knowable / true, it is hard to get comfortable with the perfect competition theory… as it relies on perfect knowledge, which by definition knowledge cannot be perfect.
It seems that a starting point for Soros is to better understand the connection between thinking and reality. Isn’t that what Ayn Rand’s Atlas Shrugged is all about? In her novel, we see how reality changes as the country’s thinking and morality changes. Atlas Shrugged seems to relate to these ideas, but I need to spend more time thinking about it…
Changing views of the world do in fact change the world around us. And the world around us changes our views. There is a feedback cycle which we will explore below.
Fallibility and Reflexivity
One is that in situations that have thinking participants, the participants’ view of the world is always partial and distorted. That is the principle of fallibility.
The other is 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.
So, fallibility says that we all have a distorted view of the world. And reflexivity says that these distorted views can impact the situations in which they’re derived.
Economic theory is built on the concept of equilibrium, and that concept is in direct contradiction with the concept of reflexivity
Warren Buffet has long said that he enjoys the fact that there are generations of finance practitioners being disillusioned through MBA schools. They are being taught broken theories like Efficient Market Hypothesis. He views this as an advantage as he can play against those who view the world through what he sees as a flawed framework.
Soros is saying something very similar here. You can prosper in markets by the frameworks that you use to make decisions. While it’s important to build the tactical skills to do good work and analysis, the framework and philosophy that you use as your guide is arguably far more important. Don’t overlook the necessity of developing a philosophy by solely focusing on specific skill development.
Fallibility - what leads to our distorted views of the world?
Soros explains that the world is far more complicated than our capacity to comprehend it. We make up mental models and short cuts to simplify this complexity into something digestible. However, in cutting the world up this way, we create a distorted view of reality that oversimplifies and/or misreads the world.
Reflexivity - applies solely to situations that involve thinking. You will not find reflexivity in purely natural phenomenon that lacks thinking participants.
Cognitive function - understand the world in which we live
Causation: the world determines our views: world ——→ thinking
Participating or manipulative function - change the situation to our advantage
Causation: the intentions of the participants have an effect on the world: thinking ———> world
When the independent variable of one function is the dependent variable of the other, neither function has a genuinely independent variable
Outcomes are liable to diverge from expectations and intentions.
The feedback loop is that our views influence events, and events influence our views, which creates a refined view that further influences events. etc. etc.
Negative feedback - brings the participants views and the actual situation closer together
Self correcting - meant to ultimately land at an equilibrium as views and actual events converge
Positive feedback - drives the two further apart
Self reinforcing - interpretations of reality that are distorted and produce results that drive the distortion further
Reality
There is only one external reality but many different subjective views
What Soros is saying here is that there is only one true course of events. But, each participant may view this event differently, and form their own (distorted) view of the world, which becomes their reality.
Do these individual participant views become separate realities? One could say that they are the representation of reality to each participant and therefore reality as each participant knows it. If that’s true, then understanding how someone views the world and reality can help you interact with them and their world.
Understanding natural events can be helpful to learn about the world as they are free from the manipulative function (natural events are free from the effects of thinking on the world around us).
Uncertainty
Uncertainty comes into play in two instances i) we act on the basis of imperfect understanding (the input) and ii) results of our actions will not correspond to our expectations (the output).
In other words, there is uncertainty in our initial understanding of knowledge and uncertainty in the outcome versus intention.
Conclusion
Anyway, this is a random stream of notes following my reading of Soros’ essay. I plan to spend more time reading his thoughts on these topics to develop my understanding. I’ll hopefully write more posts on this topic as I find anything relevant worth sharing.
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Until next time.
John Galt