How to use the theory that made George Soros an investing legend

Most of us will never beat legendary fund manager George Soros, one of the best investors of all time, but you could improve your own returns by adopting his mind-blowing theory. Here's how you can use it to your advantage.

• George Soros credits much of his immense investing success to the “reflexivity” theory he began developing in the 1950s. It holds that investors’ perceptions of what’s going on can actually influence what’s going on, and in turn, influence their perceptions all over again.

• The reflexivity theory is well-positioned to explain the boom-and-bust pattern that has played out throughout history in asset prices.

• The theory also makes this point clear: as an investor, it’s important to pay attention not just to the fundamentals, but also to the way that other investors perceive those fundamentals.

Most of us are never going to beat legendary fund manager George Soros, one of the best investors of all time. He achieved annual returns of more than 30% a year, for over 30 years – and he famously pocketed a cool $1 billion in a single investment in a single day. But you could improve your own returns by adopting his “reflexivity” theory, which he credits for his success. It explains how investors’ perceptions of what’s going on can actually influence what’s going on, and in turn, influence their perceptions all over again.

So here’s what his mind-blowing theory is all about and how you can use it to your advantage.

So what’s this theory, then?

Soros, who began developing his theory of reflexivity back in the 1950s, breaks it down into two main principles: fallibility and reflexivity itself.

The principle of fallibility says, essentially, that financial markets are driven by people, and people are fallible in their ability to understand reality. As humans, we’re imperfect, and our view of reality (especially highly complex realities like financial markets) is heavily influenced by all our assorted cognitive biases and emotions. As a result, we tend to make mistakes when assessing the market’s underlying fundamentals or when trying to anticipate what’s going to happen next.

The principle of reflexivity, meanwhile, highlights the feedback loop between what human investors think about reality, and that reality itself. For instance, when investors are optimistic about the economy, they might start to buy stocks, anticipating that economic growth will translate into nice profits. That buying, then, pushes stock prices up and boosts the value of the companies today. That, in turn, leads companies to invest in more projects, which in turn can boost consumption and profits. Those improvements, then, can increase investors' confidence in the economy even further, leading them to be even more optimistic, continuing the cycle in a self-reinforcing pattern. Put more simply, the expectation of a good environment can create a good environment.

Unlike in the case of most natural phenomena – in which events unfold irrespective of the views held by the observer – in financial markets, beliefs impact the fundamentals, and the fundamentals affect beliefs in a loop.

At any given moment, different investors will have different (biased) views of reality and so different feedback loops will be at work. That creates the irregular price movements that we’re used to seeing in markets. Sometimes, however, one set of beliefs will start to dominate, and when combined with those self-reinforcing “loop” patterns, they can produce prices that substantially and persistently deviate from what’s considered “fair value”. But nothing lasts forever: eventually, the divergence will become too extreme, investors’ perception of reality will start to change, and the feedback loop will start to move in the opposite direction.

Why does this theory even matter?

Like economist Hyman Minsky’s theory of instability, Soros’ theory of reflexivity directly contradicts traditional economic theory, which states that markets are always moving toward balance, that investors are fully rational, and that prices discount the future perfectly and efficiently.

The way Soros sees it, markets are highly unstable, investors have a distorted view of reality, and prices don’t just discount the future: they also help to shape it. And while traditional economic theory emphasizes precision and clear causal links, Soros throws all of that out the window, saying essentially that reality is too complex to be perfectly modeled and that prices often spectacularly deviate from their fundamentals.

In fact, Soros’ reflexivity theory is well-suited to explain the historical boom-bust pattern in asset prices. Take the global financial crisis of 2008-09: the belief that house prices could only go up created a positive feedback loop between market participants' behavior and the underlying reality. As more and more people bought homes and invested in mortgage-backed securities, house prices did increase, and that did reinforce the belief that housing was a safe and lucrative investment. But that perceived safety wasn’t real, and as house prices began to decline, market participants' perceptions shifted, and the positive feedback loop turned negative. Investors soon came to expect the worst, which exacerbated the issues in the financial system and deepened the actual crisis. The theory can also explain the recent crisis at Silicon Valley Bank, which collapsed when depositors perceived it as unsafe and rushed to take their money out, turning the negative perception into real losses.

How can you use the theory?

There are two ways. The first is to bet on the feedback loops themselves and try to ride the momentum of the assets that are most exposed to them. For instance, you could buy tech stocks on the basis that they’re likely to benefit heavily from the development of artificial intelligence (AI) and that they’re perceived to be more defensive than other cyclical sectors. You could also follow a trend-following strategy, buying assets that are seeing the most positive momentum and shorting the ones seeing the most negative momentum. Or, you can try to anticipate when a new narrative is emerging and likely to gain steam, a strategy I explained here.

The second is to try to identify when a trend may be exhausted, and bet on the inevitable reversal. In that case, you’d try to identify the assets that have benefited most from the positive feedback loops and bet against them (or at the very least make sure you’re not overexposed to them). But be cautious: Soros himself warned that while the direction and reversal are predictable, the timing and the magnitude aren’t. Or, you can buy assets that are most likely to be trading at a discount to their fundamental value, as we explained here.

The good news is, there’s no single, right way to make money in markets. But by paying attention to how investors' perception of reality can actually influence reality, and by having a clear strategy on how you might benefit from it, you’ll be one step closer to that $1 billion payout.

Stéphane Renevier is a global markets analyst at finimize.

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