Alchemy of Finance

Reading the Mind of the Market

Book by George Soros

Article and Review by GlobalMacroForex

George Soros is an investing legend, known for profiting from the collapse of the British pound in 1992.  His flagship investment fund Quantum has produced over $20 billion in profit for him personally.  In this book, Soros covers many topics including:

·      Reflexivity Theory

·      1960s Conglomerate Boom

·      Regan’s Imperial Circle

·      His trade Diary

Let’s dig in…

Reflexivity Theory

George Soros disputes classical economics and argues that the market is not efficiently moving towards equilibrium.  Instead, he argues that it is always in disequilibrium because the market’s own opinion about where it should be influences where it is.   Similar to the Heisenberg uncertainty principle in quantum physics (where the act of observing changes the observed phenomenon), George Soros proposes reflexivity theory.  In reflexive theory, as the market believes a certain bias about prices, prices move in the biased direction, thus confirming its own trend in a self-reinforcing cycle.

“I do not accept the proposition that stock prices are a passive reflection of underlying values, nor do I accept the proposition that the reflection tends to correspond to the underlying value.  I contend that market valuations are always distorted; moreover-and this is the crucial departure from equilibrium theory-the distortions can affect the underlying values.”

According to Mr. Soros, this reflexive concept can be seen in all markets from currencies to stocks.  He argues that market participants bid up prices to an unsustainable level.  Then when reality fails to meet these grandiose expectations, a new negative bias is formed, in which market participants bring the prices back down.  George Soros proposes the following rules for his theory:

1.   Markets are always biased one direction or another

2.   Markets can influence the events in which they participate

George Soros compares economics, which is a social science, to the natural sciences.  He notes that the hard natural sciences have an advantage in understanding the world because the phenomenon occurs independently of the scientist, while in social sciences, the observer is part of it.

1960s Conglomerate boom

George Soros argues that the stock market prices of conglomerates merging in the 1960s gives a real world example of his reflexivity theory.  He points out how during this time period, conglomerate corporations were attaining higher earnings via mergers.  As long as the acquiring company had a higher stock valuation than the acquired company, the acquirer could issues shares to pay for the merger.  This created an expectation from the market of higher and higher earnings growth from acquisitions and pushed stock multiples much higher than was supported by real earnings growth.

George Soros claims he knew this cycle would be self-reinforcing and correcting, and he profited from the rise and fall of these merger companies.

Regan’s Imperial Circle

George Soros disliked Ronald Regan and nicknamed Regan’s economic policy the “Imperial Circle”.  According to Soros, the path of the US dollar under the policy at the time the book was written was unstable.  Soros argued the following relationships as being true:

A stronger US dollar makes the trade deficit worse

According to some economists, having a stronger currency makes exports less competitive to foreigners.  In addition, it encourages more imports because the stronger currency makes foreign products cheaper.  Since the US trade deficit was large and growing during Reagan’s presidency, Soros hypothesized that the stronger US dollar would make it even worse.

A higher budget deficit makes interest rates higher than they would be otherwise

When the government spends money, it has to either collect taxes or borrow.  If it isn’t collecting enough taxes (budget deficit), then the extra borrowing from the government will raise the overall interest rate higher from more borrowing.  However, George Soros points out how foreign savers allow the economy to consume more than produces and drives the interest rate down.  It’s only when capital inflow ceases to match the budget deficit, the problem becomes acute.  Then a crisis forms where foreigners are less willing to hold dollar assets and dump US dollars in mass.

As this cycle is a self-reinforcing feedback loop (as all of reflexivity is), Soros has chosen to metaphorically represent it as the “Imperial Circle” (although no explanation is given why it is imperial).  Under the Imperial Circle model, market participants push the US dollar higher, which increases the trade deficit and decreases interest rates further.  The trade deficit and budget deficit only get worse, as the government borrows more pushing the dollar even higher, and more market participants jump on board.  This situation is unsustainable and leads to a reflexive crash, with a rise in interest rates and a fall in the dollar.

Trade Diary

The second half of the book is an experiment in which George Soros gives us his thinking about trading as he does it.  It’s basically a trading diary or journal.  It updates us with the positions, price changes in his fund, and his rational for putting on trades. 

One surprising aspect to the reader is how often George Soros is wrong.  He frequently makes predictions for real world events that did not materialize.  He points out that under a hypothesis testing model, it’s still entirely possible to make money even when you are wrong about the real world events.  The emphasis he puts is on recognizing the reflexive nature of prices to be one step ahead of the curve.


Although George Soros made billions in the markets, one gets the impression that he doesn’t really respect markets.  He explains this as a necessity of anyone who wants to speculate:

“Indeed if one believes that the market is always right there is little to be gained from having a feedback mechanism because the prospect of outperforming the market becomes a matter of pure chance.”

Overall, he presents his reflexive theory, and evidence in both the go-go 1960s conglomerate boom as well as the currency markets.  He gives us a glimpse into his trading thinking, but leaves us more on our own for how to apply this concept to our own portfolio.  He certainly still finds a need for fundamental analysis.  But he thinks that fundamental analysis is a static picture, while reflexivity is a dynamic one.