Reflexivity - What Does That Mean?

Last post I discussed a new book by George Soros covering the current credit crisis and rehashing his theory of reflexivity. This post will explore the framework of Soros' "theory" and discuss whether it is of any value to anyone other than Soros. Soros insists that now more than ever the theory can guide and help us through this difficult time and failure to recognize its potential now will set us back severely in the future.

I don't doubt that reflexivity is meaningful to Soros. He has a long track record of success in both business and philanthropy, but is it really something that both policy makers and business people can apply to the current situation on their own without a brain transplant? :)

Soros' basic point......... as I understand it....... is that whenever we try to analyze human behavior or events that involve human participants we are unable to gain any true knowledge into what is going on. We can formulate working hypotheses that may be able to explain certain processes, but these postulates are only useful as long as they work. It is basically inevitable that they will be proven wrong as the bias that facilitated their utility disappears or is revealed. Mankind's understanding of ourselves and the universe around us is constantly changing / evolving, that in turn will effect what humans do. How can we have some uniform theory or principles governing human behavior if that is the case? Soros' point is that we can't ....... at least in the traditional sense .......... of developing some kind of math problem or theorem that guides us.

So what can we do? First we can recognize our inability to gain true knowledge of the human condition as it extends to business, politics, friendship, whatever the issue may be. Second when we do try to "understand" a certain process or issue we can try to identify two of its main components.

The first component is the mechanics of the actual underlying process. What is the underlying trend and what are its effects / implications? He calls this the "cognitive function" because we are just trying to get as unbiased an understanding of what is happening without judging how or why.

The second component is what he calls the "participating function" or manipulative function. This addresses the bias possessed by participants in the process and any regulatory authorities which are monitoring or supervising the process. Sadly, they tend to perceive the process they are participating in as an absolute governed by some kind of universal law when in fact they are just operating under the prevailing bias of the moment. The list and examples of these is long......... Nasdaq stocks in 2000, real estate market over past five years, value traps in banks and financials over past 12 months.

The maximum profit opportunities in financial markets tended to arise for Soros when he was able to develop some particular insight into the underlying trend and then make some kind of unbiased assessment as to its strength or potential. When the underlying fundamentals reached a point far enough away from the prevailing bias it was then an optimum time to take major positions or make major bets in a certain direction, as when the prevailing bias was recognized as false the bottom tends to fall out of the market and windfall speculative profits might be made.

Soros use of this theory of reflexivity has helped strengthen his conviction at certain times and enabled him to stay and make large profits while others folded or doubted themselves. There are of course several issues with this approach.

Mainly is there anyone other than Soros that is really capable of applying this theory? Who is smart enough or experienced enough to possess the judgment to correctly analyze the current trend and then also be able to tell when the prevailing bias has become unsustainable?

My personal opinion is that most people cannot apply this theory for any use. It may provide a useful framework for making decisions under uncertainty, but it seems to me that everyone who applies it will apply it differently due to their own bias and misconception.

I don't think that is enough though. I think to fully explore the theory we will have to work through two or three examples of unfolding trends /bias and make some forecasts regarding the eventual developments using the theory.

Then maybe in retrospect 2 -3 years from now we can see how my own bias' clouded my analysis at this time.

-BG