George Soros wrote The Alchemy of Finance. He is so famous that I think he does not need an introduction. In this book, he introduces the theory of reflexivity which is his theory to explain the behaviour of the financial markets.
Layout of The Alchemy of Finance
The Alchemy of Finance has five parts with a foreword, a preface, an epilogue, and an appendix.
Part I is Theory which contains four chapters. It propounds the theory of reflexivity.
Part II is Historical Perspective and has five chapters. This part explains the economic and financial history with the hypothesis outlined in Part I.
Part III is The Real-Time Experiment. It also has five chapters. It consists of a real-time experiment which is both test and prediction at the same time.
Part IV is Evolution and has just two chapters. It evaluates the results of the real-time experiment.
Part V is Prescription. It consists of four chapters. This part contains the author’s recommendations for economic policy.
The author discusses the implications of reflexivity outside the sphere of finance and provides his own answers to some metaphysical questions in the epilogue.
Highlights
What is the theory of reflexivity? Reflexivity comes from the word “reflexive” which means the components influence each other mutually.
The author opines that there is no equilibrium in the financial markets as propounded by classical economic theories because buy and sell decisions are based on expectations about future prices, and future prices, in turn, are contingent on present buy and sell decisions. It is a loop in effect.
Reflexive processes will lead to excesses. The participants cannot prevent a boom from developing even if they recognize that it is bound to lead to a bust. But it can be aborted or diverted at any point.
He acknowledges that reflexivity does not operate in all markets at all times. But when it occurs, there is no limit to how far away both perceptions and events can move from anything that could be considered equilibrium
In a sense, what makes market participants’ understanding imperfect is that their thinking affects the situation to which it relates. Thus, reality depends on participant’s perception. Decisions are also made based on an imperfect understanding of the situation.
The trend in stock prices is a composite of the underlying trend (fundamentals) and the prevailing bias (participants perception). The author thinks that fundamental analysis can establish how underlying values are reflected in stock prices, while reflexivity theory shows how stock prices can influence underlying values. In short, one gives a static picture, the other a dynamic one.
According to the author, financial success depends on the ability to anticipate prevailing expectations and not real world developments. Based on the market behaviour, I feel that it is true.
Conclusion
Technically, this is not an investment book. The author has also mentioned in the book that this is not a get-rich-quick guide. This is a book for the author to share his theory, thus it resembles a philosophy book. However, as the author dabbles in the financial markets (and is a successful trader), his theory of reflexivity rings true to me and might provide some help in investing.
I will end this with some quotes from the book.
“Making an investment decision is like formulating a scientific hypothesis and submitting it to a practical test. The main difference is that the hypothesis that underlies an investment decision is intended to make money and not to establish a universally valid generalization.”
“Using leverage can produce superior results when the going is good, but it can wipe you out when events fail to conform to your expectations.”
“Reform usually occurs after a crisis, not before.”
“The fact that no system is perfect is not a valid argument against trying to perfect the system.”
Recommended book
If you are interested in The Alchemy of Finance, you may get the book through one of the links below*.
Get the book here from Kinokuniya Malaysia
Get the audio book here from Rakuten Kobo
*Disclosure: The links are affiliate links. If you buy the book using one of the links, I might get a small commission from your purchase.