What is the theory of reflexivity? How does it function?

By: ISL | 28 February, 2023

The Theory of Reflexivity connects the trader's perceptions and market’s actuality through a self-fulfilling loop. It may result in price movements that consistently and noticeably depart from the equilibrium price.

• The successful investor and philosopher George Soros think that stock market volatility results from the shifting opinions of all investors. He contends that these impressions are more influenced by how people perceive reality, which is affected by many macroeconomic and psychological aspects, than actual events. Then again, what exactly is this General Theory of Reflexivity? What benefits does it offer traders? What are the theory's lessons, exactly?

In this article, let's understand the reflexivity concepts in depth.

What is reflexivity, and why is it important?

• Let's first study what it means, in general, to grasp better what it means in economics. Reflexivity is the term used to describe analysing one's beliefs, attitudes, and actions when conducting research and their potential impact. The concept of reflexivity refers to a movement that affects or returns to the source.

What is the Theory of Reflexivity?

• George Soros adapted Karl Popper's intellectual "Theory of Reflexivity" to explain market movements. He contends that most accepted economic theories, including equilibrium, reasonable expectations, and the efficient market hypothesis, conflict with reflexivity.
• According to the economics theory of reflexivity, investors judge more based on how they perceive the situation than actuality. As a result, there is a feedback loop where traders' perceptions influence the fundamentals of economic activity, influencing traders' perspectives.
• The following concept serves as its foundation: price fluctuations that considerably and repeatedly deviate from equilibrium prices (price levels that strike a balance between supply and demand) can lead to feedback loops: expectations and the realities of the economy. For instance, rising market prices draw customers whose purchases push prices even further until the cycle is unsustainable. It serves as an example of a positive feedback loop.
• Let's look at an illustration to get a basic understanding of this notion. If investors feel that markets are efficient, their investment portfolios will change, influencing the nature of the markets in which they are trading.
• This is another interesting illustration. Before the financial crisis of 2008, rising real estate values encouraged banks to expand their land mortgage lending, which in turn helped raise real estate prices. As a result of unchecked price increases, a price bubble eventually formed, which finally burst, causing a financial disaster and a devastating recession.

Important aspects of the Theory of Reflexivity:

• Fundamentals are impacted by pricing, which in turn modifies expectations and influences prices. This cycle of events keeps repeating itself.
• Perceptions rather than reality serve as the foundation for reflexivity. The actions resulting from these views, which change investors' perceptions and prices, impact facts or fundamentals.
• The idea of economic equilibrium is undercut by reflexivity. So prices may deviate sharply and constantly from equilibrium values over time.

How does it relate to financial markets?

• Let's use an illustration to clarify. According to its market valuation, XYZ Co. has yet to produce more revenue, but the stock price has continued to rise. This results from the stock receiving several positive evaluations from people. This belief may be based on several presumptions, including increased profitability by innovation, growing market share, or having access to a profit switch. Or, investors may continue to buy the company because they think its strong past performance will lead to continued growth.
• Investors are drawn to a company that isn't profitable by bright ideas and ambitious aims. What matters, in this case, is how positive beliefs have dramatically impacted the corporation XYZ's subjective reality.

In what ways does George Soros' economic reflexivity theory relate to the financial markets?

• Impact on the company's value: The Theory of Reflexivity states that a feedback cycle causes prices to rise above the new equilibrium level. This impacts the company's valuation, stock price, and overall asset value.
• Asset formation: Because of optimistic beliefs and favorable company evaluations, people invest money, which results in significant asset formation.
• Stock prices reflect underlying values: Stock prices significantly impact the value of investors and companies. This affects how much money is invested by firms and investors.

Conclusion:

• In conclusion, the Theory of Reflexivity holds that investors make decisions based on perceptions rather than facts. They must therefore comprehend how market sentiment impacts equity pricing. You can include reflexivity in your framework for evaluating the market as an investor. You will be better able to identify potentially spectacular trades and be made aware of significant price/reality divergences ripe for the taking.