Reflexivity & the Fall of the Efficient Market Hypothesis

Soros – “The Efficient Market Hypothesis has failed…”

In the aftermath of the 2008 Global Financial Crisis, in an interview with CNN Business, George Soros calmly said: “basically the efficient market hypothesis has failed. We must recognize that it has failed and economists need to find a new understanding of financial markets.”

The interviewer, momentarily at a loss for words, pushed Soros on this point, defending the Efficient Market Hypothesis.

Soros calmly responded: “this is what science is, it’s trial and error. There has been an error…. But unfortunately, we don’t have a properly developed alternative, and that’s what we’re looking for.”

The interviewer, pushing further, “well it begs the question, will you know when you’ve found it?”

Soros smiled, “well, we will see. There has to be a rethinking and reworking of the teachings of economics. It has to be quite profound. I myself am one of the proponents of one of the alternatives.”

A year earlier, in October 2009, George Soros laid out one of these alternatives during a five-part lecture series. In these lectures, Soros explains how, over the course of his life, he has developed a mental framework that has helped him both make money as a hedge fund manager and spend money as a policy-oriented philanthropist. Soros stresses one thing, however. This mental framework is not about money, but rather the relationship between how people think and the underlying reality. A long-time student of philosophy, it is no surprise that Soros’s framework is deeply rooted in philosophical teachings – specifically that of Karl Popper. The mental framework, now known as the ‘Theory of Reflexivity,’ is actually a combination of two common concepts: fallibility and reflexivity. In his first two lectures, Soros explains these concepts in general terms and then applies them to financial markets.

The Feelings of a Failed Philosopher

For those who are unfamiliar, George Soros founded Soros Fund Management LLC in 1970. Soros Fund Management was also the primary adviser to the Quantum Family of Funds – a variety of investment funds dealing in international investments from public and private equity deals to fixed income and foreign exchange markets. Since inception, the firm has been reported to be one of the most profitable hedge funds in the industry, averaging a 20%+ annual rate of return for 40+ years. Soros is also infamously known as the “man who broke the Bank of England.” In the weeks leading up to the 1992 “Black Wednesday” market crash, Soros and the Quantum Funds earned $1.8B as a result of shorting the British Pound against the German Mark. Suffice to say that, in traditional markets, George Soros is a legend.

Before we dive into the Theory of Reflexivity, it is necessary to understand how Soros came to these conclusions in the first place. Soros began developing his theories while attending the London School of Economics in the 1950s. Having finished his exams a year early, Soros was allowed to choose a mentor. He chose Karl Popper, an Austrian philosopher, and author of “The Open Society and Its Enemies”. The essence of Karl Popper’s work is that empirical truth cannot be known with absolute certainty. Furthermore, scientific laws cannot be known beyond a shadow of a doubt. One failed test is enough to falsify any law, while no amount of confirmation is enough to verify with absolute certainty. These teachings resonated deeply with Soros.

 

It just so happened that while reading Karl Popper, Soros was also studying economics. This was where Soros began to more concretely develop his theories and philosophy. During his studies, Soros began to notice huge contradictions between Popper’s writings, the emphasis on an individual’s imperfect understanding of the world (or any situation), and the prevailing school of thought around financial markets, which postulated perfect knowledge of a situation. This school of thought is known as the Theory of Efficient Markets and Perfect Competition, and it has dominated modern financial theory for much of the last century.

For those unfamiliar, the Efficient Market Hypothesis (EMH) postulates that the market incorporates all available information into current prices. Assets tend