George Soros’ Theory of Reflexivity

I just read a speech by George Soros where he describes what he calls the theory of reflexivity.

http://www.geocities.com/ecocorner/intelarea/gs1.html

It’s a truly fascinating idea, and another counterargument to classical economics’ assertion that markets are perfect.

In the stock market, there’s supposedly fundamentals like earnings per share and earnings growth that are determined by factors outside of the markets.  These fundamentals determine the true value of a company.  Stock prices are based on investors’ beliefs about these fundamentals.  Fundamentals may change, and beliefs may be mistaken, but the classical theory is that over time they tend to an equilibrium that accurately reflects the underlying reality.

The theory of reflexivity, on the other hand, says that people’s beliefs about market fundamentals can actually change the underlying fundamentals.  This can lead to instability and disequilibrium.

The simplest way I can explain it is with the old game rock-paper-scisors.  If I know my opponent is choosing rock, I will choose paper.  But if my opponent knows I am choosing paper, he will choose scissors.  But if I know he is choosing scissors I will choose rock, and so on forever.

The information I have about what my opponent will do changes my actions, and if my opponent has correct information about my actions he will change his actions which will cause me to change my actions…

In this game, it will always be the case that either one player has incorrect information, or one player wants to change his action.  There is no equilibrium.

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