For many decades, the reigning theory of how markets operated was called the efficient market hypothesis. This theory held that markets were capable of taking all available information into account and the market participants were able, then, to make a rational decision as to the optimal pricing of the assets which the financial instruments being traded on the market represented. This was established dogma for a very long time, with very few dissenting opinions, especially among academics who studied the world of high finance, such as economists and public policy analysts.
It makes it that much more surprising, then, that the young George Soros was able to develop a theory that ran completely contrary to this reigning orthodoxy. Soros, who had worked for over a decade on Wall Street, starting his career with the firm Singer and Friedlander, where he first became aware of the inner workings of the capitalist markets, began to see the many cracks that appeared in the efficient market hypothesis upon closer inspection. Read his profile at Business Insider.
With first-hand knowledge of the markets, from dealing with them day after day in a professional capacity, Soros began to seriously doubt the veracity of the efficient market hypothesis. He began to see that markets often acted irrationally. Participants, many times, based their decisions to buy or sell not on the underlying value of the assets or the fundamental qualities that govern their value, but instead they based it on emotional reactions to what was taking place before them. Emotions like greed, fear and even envy seemed to play an outsized role in markets that were supposedly governed by pure rationality and level-headed actors.
It was these insights that led Soros to begin developing his own theory of the functioning of markets, which he termed reflexivity. At its simplest, the theory of reflexivity recognizes the fundamental truth that asset prices are not a product of rationally acting market participants. On the contrary, the prices of assets are often materially affected by the perception that individual participants have of the perceptions of other participants. This creates a sort of positive feedback loop, whereby asset prices can become completely decoupled from the underlying fundamentals of the business or trade that those financial instruments represent. This can lead to such phenomena as bubbles, booms, busts and even stock market crashes, such as those seen in 1929 and 1987. Learn more on discoverthenetworks.org about George Soros.
But Soros didn’t merely stop at that observation. He went on to develop the theory of reflexivity into an intricate and highly applicable theoretical framework, from which he based most of his investment decisions. Of course, George Soros went on to become one of the most successful investors in history, proving once again that following the herd mentality is often times the worst way to approach investing.