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You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
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It was time for Soros to take a look at Wall StreetFascinated by Chaos From the time he was a student in London in the early 1950s, George Soros had been interested in the way the world functioned. It had been his hope not only to ponder the large questions of life but to make a sizable contribution to knowledge as well. His mentor, Karl Popper, had inspired him to think big thoughts, to develop a grand philosophical scheme. Such a scheme might benefit humanity, and it might benefit the person who came up with the scheme. Soros came to believe, in the words of his longtime friend Byron Wien, that the more youre able to define your efforts in an abstraction, the better youll be in practicality. In time, Soross interest in abstractions would lead him to the more tangible question of how financial markets worked. But to understand his theory about financial markets, the best place to begin is his general theory of life and society. One word has been key to his thinking. Perceptions. Many people have asked the same questions: What is life all about? Why am I here? How do things-the big things like the Universe, the Brain, Humankind-work? Dwelling on these questions for a moment or two, people then get on with their lives, with the practical issues of raising families, making a living, remembering to take out the trash. Philosophers, however, have made such questions their life study. And George Soros longed to be a philosopher. No single event triggered Soross interest in philosophy, yet it was there for as long as he could remember. Ever since I became conscious of my existence, he wrote in the introduction to his 1987 book, The Alchemy of Finance, I have had a passionate interest in understanding it, and I regarded my own understanding as the central problem that needed to be understood. Here then was the spark. And yet, as young Soros figured out almost from the very start, the task of unraveling the mysteries of life was nearly an impossible one. For one simple reason: To even begin to study who we are or what we are, we need to look at ourselves objectively. The trouble is that we cannot. This was a dramatic revelation for George Soros: What one thinks is part of what one thinks about; therefore, ones thinking lacks an independent point of reference by which it can be judged - it lacks objectivity. Soros wrote that in his introduction to Alchemy, a single sentence formed the core of his theoretical analysis. Unable to achieve this independent point of reference, people cannot, in effect, get out of their skins, cannot look at the world through undistorted prisms. In the early 1950s, Soros came to the conclusion that basically all our views of the world are somehow flawed or distorted. His focus became how this distortion shaped events. Equipped with these general notions of how the world worked, it was time for Soros to take a look at Wall Street. The trouble was that most people who had already tried to analyze the stock market had concluded that logic prevailed logic. It was too disquieting, not to mention too risk laden, to think otherwise when dealing in the market. Adherents of this rational school of thinking argued that because investors could have perfect knowledge of a company, every share was valued at precisely the correct price. Armed with this knowledge, investors automatically behaved rationally when presented with an array of stock choices and picked the best one. And share prices remained rationally related to estimates of companys future earnings. This was the efficient-market hypothesis, one of the most popular theories of how the stock market works. It assumed a perfect, rational world. It assumed also that all stock prices reflected available information. But while classical economics taught the concept of equilibrium, and made assumptions as if perfect competition and perfect knowledge were attainable, Soros believed he knew better. In the real world, he maintained, any theory that assumed perfect knowledge was attainable was flawed. In the real world, the decision to buy or sell was based-not on the ideals of classical economics-but on expectations. And in the real world, people could attain only an imperfect understanding of anything. The major insight I bring to understanding things in general is the role that imperfect understanding plays in shaping events. Traditional economics is based on theories of equilibrium, where supply and demand are equal. But if you realize what an important role our imperfect understanding plays, you realize that what you are dealing with is disequilibrium. And so, he noted on another occasion, he was fascinated by chaos. Thats really how I make my money: understanding the revolutionary process in financial markets. Ever since he played the Monopoly-like game of Capital during those summers on Lupa Island, George Soros was ensnared by the world of money. Though a part of him wandered freely in the intellectual realm, his practical side impelled him to study economics at the London School of Economics. To his disappointment, however, he found the subject wanting. His professors pounded home to him that economics was - or at least tried to be - a science. One could formulate theories and develop laws that governed the world of economics. But George Soros saw right through all of this. He reasoned that if economics were a science, it would have to be objective. That is, one would have to be able to observe its activities without affecting those activities. But this, Soros concluded, was impossible. How could economics pretend to be objective when human beings who were, after all, at the core of all economic action-lacked objectivity? When those same human beings, by virtue of their involvement in economic life, could not help but influence that economic life? Those who assumed that economic life was rational and logical argued as well that financial markets were always right. Right in the sense that market prices tended to discount-or take into accountfuture developments, even when those developments were unclear. Not true, said Soros. Most investors, he once explained, had come to believe that they could discount what the market would do in the future, that is, take future developments into account in advance of their occurring. To Soros this was impossible. To him, any idea of is by definition going to be biased and partial. I dont mean that facts and beliefs exist autonomously. On the contrary, what I have argued in expounding the theory of reflexivity is that what beliefs do is alter facts. In effect, then, market prices were not going to be right, because they always ignored the influences that could and would come from future developments. Market prices were always going to be wrong because they offered not a rational view of the future but a biased one. But distortion works in both directions, contended Soros. Not only do market participants operate with a bias, but their bias can also influence the course of events. This may create the impression that markets anticipate future developments accurately, but in fact it is not present expectations that correspond to future events but future events that are shaped by present expectations. The participants perceptions are inherently flawed, and there is a two-way connection between flawed perceptions and the actual course of events, which results in a lack of correspondence between the two. I call this twoway connection reflexivity. The two-way feedback between perception and reality-what Soros called reflexivity-formed the key to his theory. Soros was convinced that what explained the behavior of financial markets was not the efficientmarket hypothesis, but a reflexive relationship that existed between the biases of investors and what he called the actual course the economic fundamentals of firms negative, caused the price to rise or fall. That bias operated as a self-reinforcing factor, which then interacted with underlying trends to affect investor expectations. The resulting price movement might lead management to repurchase shares or enter upon a merger, acquisition, or buyout, which in turn influences the fundamentals of the stock. The price of a stock, then, was not determined by incisive reaction to attainable information. Rather it was a result of perceptions that were as much the outcome of emotions as of hard data. As Soros wrote in The Alchemy of Finance: When events have thinking participants, the subject matter is no longer confined to facts but also includes the participants perceptions. The chain of causation does not lead directly from fact to fact but from fact to perception and from perception to fact. Soross theory embraced the notion that the prices investors paid were not simply passive reflections of value; rather, they were active ingredients in making a valuation of the stocks worth. A second key to Soross theory, then, was grasping the role played by misconceptions in shaping events. Misconceptions, or, as he sometimes called them, divergences between a participants thinking and the actual state of affairs, were always there. Sometimes, the divergence was reasonably small and could correct itself. He called this situation near-equilibrium. Sometimes, the divergence was large and not self-correcting. This situation he termed far-from-equilibrium. When the divergence was large, perception and reality were far removed from one another. No mechanism existed to push them closer together. Indeed, forces were at play tending to keep them far apart. These far-from-equilibrium situations took one of two forms. At one extreme, even though perceptions and reality were far apart, the situation was stable. Stable situations were of no interest to Soros the investor. At the other extreme, however, the situation was unstable, and events galloped ahead so quickly that the participants views could not keep up with them. This situation was of extreme interest to Soros. The gap between perception and reality was wide because events were running out of control, a situation found typically in boom/bust sequences in the financial markets. Soros thought of self-reinforcing but before eventually have to be reversed. Always the potential existed for such boom/bust sequences. Soross investment philosophy held that boom/bust sequences are prone to develop because markets are always in a state of flux and uncertainty. The way to make money was to look for ways to capitalize on that instability, to search for the unexpected developments. |
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