George Soros: Investing Rules And The Theory of ReflexivityVW Staff
Below you can find the investing rules of George Soros as discussed in the Morgan Creek Capital Management's fourth quarter letter to shareholders.
George Soros: Investing Rules And The Theory of Reflexivity
George Soros is widely regarded as one of the preeminent investors of our time after compiling a track record over four decades from 1969 to 2009; that is, without question, Hall of Fame material. Given that there are simply not that many investors who have track records of this duration, it is tough to make direct comparisons at all, and making comparisons across decades is tough because of the very different economic and market environments that exist from decade to decade. For example, making good returns from 1969 to 1982 was pretty darn tough as the S&P 500 was essentially flat during those 14 years, while it was pretty easy to make solid returns from 1982 to 2009 as the S&P 500 compounded at 12.3% and went up nearly 20 times (when you put the whole 41 year period together the S&P 500 compounded at 9.4% and turned a $10,000 investment into just under $400,000). Interestingly, there is one investor who was in the market the entire time as George Soros (and is often touted as the world’s greatest investor, for some pretty good reasons related to consistency and longevity) and actually has a track record that we can stack up side by side with George to gain some perspective. Warren Buffet closed his private partnership (BPL) to new capital in 1966 and, by 1969, had transitioned to running as a closed end fund named Berkshire Hathaway (named after the original textile manufacturer that he bought a controlling interest in and later took outright control). So when George Soros started taking outside capital into his Double Eagle partnership in 1969 (where he was an Associate at Arnhold and S. Bleichroeder), we had ourselves a horserace. George eventually spun himself out in 1973 into a private firm, Soros Fund Management, and later established the Quantum Fund as their primary investment vehicle. Soros was the primary Portfolio Manager for many years, but was very successful in building an extraordinary team of very talented investors to work at Quantum and he eventually ceded the CIO responsibilities to Stanley Druckenmiller (who also has a Hall of Fame track record of his own in compounding client wealth in his fund, Duquesne Capital). George Soros became less active in the late 2000s and Quantum actually returned all outside capital in 2011, converting to a Family Office to concentrate on running the Soros family and Foundation assets.
track record that we can stack up side by side with George to gain some perspective. Warren Buffet closed his private partnership (BPL) to new capital in 1966 and, by 1969, had transitioned to running as a closed end fund named Berkshire Hathaway (named after the original textile manufacturer that he bought a controlling interest in and later took outright control). So when George Soros started taking outside capital into his Double Eagle partnership in 1969 (where he was an Associate at Arnhold and S. Bleichroeder), we had ourselves a horserace. George Soros eventually spun himself out in 1973 into a private firm, Soros Fund Management, and later established the Quantum Fund as their primary investment vehicle. George Soros was the primary Portfolio Manager for many years, but was very successful in building an extraordinary team of very talented investors to work at Quantum and he eventually ceded the CIO responsibilities to Stanley Druckenmiller (who also has a Hall of Fame track record of his own in compounding client wealth in his fund, Duquesne Capital). George Soros became less active in the late 2000s and Quantum actually returned all outside capital in 2011, converting to a Family Office to concentrate on running the George Soros family and Foundation assets.
So for the 41 years from 1969 to 2009, we have good data on Quantum vs. Berkshire (thanks to Veryan Allen at @hedgefund who collected the information and calculated the returns) and the results are nothing short of astonishing. Warren compounded wealth over that period at a stunning 21.4% (more than double the S&P 500 return over the period) and would have turned a $10,000 investment into $28.4 million. George Soros , however, did a just little bit better, compounding at 26.3% (which doesn’t sound like that big a difference) and, through the miracle of long-term compounding, turned that same $10,000 original investment into an extraordinary $143.7 million. Now clearly very few investors benefitted completely from any of these three track records. Those numbers assume that you reinvest all the dividends, never take any distributions and invested at the beginning and stayed invested until the end. Forty-one years is a long time to stick to one strategy. In fact, to provide some perspective on how hard it is to stick to any strategy long-term, we have data that shows that over the past 20 years (a period only half as long as the George Soros period) the S&P 500 Index has compounded at 8%, yet the average investor in mutual funds has only made 3% (from the Dalbar Study) because investors are not very good at sticking to a strategy and letting compounding work for them. As famous stock operator Jesse Livermore once said, “It was never my thinking that made the big money for me, it was always my sitting.” Understanding full well that most investors only earn a fraction of what is available in any investment strategy, simple math says that a fraction of George or Warren’s performance is far superior to a fraction of the S&P 500 performance. The primary point of all of the performance math here is to establish that George Soros is one of the world’s greatest investors and we would probably be wise to pay attention to any lessons he is willing to share with us and, fortunately, he has been willing to share many of them over the years. I have compiled a collection of “Sorosisms” from various sources over the years and have tweeted many of them individually to provide insight on a particular event or opportunity in the market, but for this letter I have selected my favorite 23 (many from a great compendium of 50 of George’s best at thinkinginvestor.com) to discuss the George Soros philosophy of Reflexivity and make the case for why it is so important for investors to understand, particularly today.
George Soros was born on August 12, 1930, as Schwartz György, in Budapest, Hungary. His father later changed the family name from Schwartz (“black,” in German) to George Soros (“will soar,” in Esperanto). George Soros survived the Nazi occupation of Hungary and moved to England in 1947 where he enrolled at the London School of Economics and became a student of the philosopher Karl Popper. In 1951, he earned a BSc in Philosophy and in 1954 he completed a PhD in Philosophy. George Soros was deeply impacted by his mentor and embraced core tenets of Popper’s teachings including the Human Uncertainty Principle (a foundational element of Reflexivity) and the Advocacy of Falsification (the construct that empirical truths cannot be proved conclusively by observation, but they can be falsified). The popular concept of the Black Swan is an example of the Falsification construct. The idea that all swans are white cannot be validated by the observation of white swans (no matter how many white swans one observes), but it can be falsified by the observation of a singe black swan. Popper’s theories were rooted in the ideas of Human Fallibility (the idea that thinking participants’ knowledge of any situation is always partial and distorted by their biases and misconceptions) and Complexity Theory (the idea that the world is more complex than our capacity to understand it), which, ultimately, led to the concept of Reflexivity (that participants partial, biased or false views led to inappropriate actions that impacted the actual system in which the participants are interacting). To Popper, Human Uncertainty arose from two notions: 1) that it was impossible to know what others know, or don’t know, and 2) that other participants may have different interests, or values, relating to the system in which you are engaged. George Soros concluded that his newly found core philosophical tenets contradicted the ideal of perfect knowledge existing in markets or economics and began to develop his own philosophy based on the idea of imperfect understanding. George Soros came to embrace the idea that there is a two-way interaction between the Cognitive (how we understand the environment in which we interact, how reality determines our view) and the Manipulative (how we change the environment in which we interact, how our intentions impact the world). In essence, he postulated that the actions we take are influenced by how we perceive the environment (which, by definition will be skewed by our biases or lack of complete information, he called these fertile fallacies) and those inappropriate actions, in turn, impacted the environment, which would then change our subsequent view (in an endless feedback loop). The notion of evolution would lead to continuous, self-reinforcing cycles (both virtuous and vicious) that he reasoned could explain the boom/bust cycles observed in financial markets.
The principle of Reflexivity is based on the construct that markets tend toward disequilibrium, rather than equilibrium, because the actions of the participants are exaggerated by their biases, or misconceptions, about the market itself and their subsequent actions then change the valuation of those markets which further reinforces those biases in a self-reinforcing feedback loop. George Soros does not mince words when he says, “the concept of a general equilibrium has no relevance to the real world (in other words, classical economics is an exercise in futility).” As the picture above summarizes, Reflexivity Theory (RT) is fundamentally different from classical Equilibrium Theory (ET) on five primary levels: 1) ET makes the assumption that market participants have instantaneous access to perfect information, while RT says that market participants act on imperfect information, 2) ET assumes that markets are composed of rational actors, while RT acknowledges that market participants are influenced by their own biases and misconceptions, 3) ET relies on the construct that markets move quickly and efficiently toward a state of equilibrium, while RT says that markets are dominated by states of disequilibrium resulting from feedback loops that lead to virtuous (boom) and vicious (bust) cycles, 4) ET says that market theorists and observers are external to the system, while RT says that all members of the system are part of the market observed, and 5) ET assumes that the theories on the markets do not influence, or change, the markets while RT believes that market theories are a direct means of changing the systems described. George Soros would clearly not have been a fan of the economic theory I was subjected to at the University of Chicago (the center of the Efficient Markets Hypothesis (EMH) universe) and would argue that ivory tower economic theory replete with simplifying assumptions about rational expectations and perfect information are a waste of time for investors who must earn their living in the real world. He would argue that markets are highly IN-efficient, spending the bulk of the time in varying states of disequilibrium, resulting in many opportunities for investors to earn excess returns. Given his track record of generating excess returns, it is hard to refute his logic. In reflecting on this point, one hypothesis could be that the core philosophy an investor adopts could (in a Reflexive manner) actually increase the likelihood that they achieve excess returns over time. Similar to how an outstanding golfer increases the odds of hitting consistently good drives by visualizing hitting down the middle of the fairway in advance, while the duffer consistently slices into the woods by worrying about slicing into the woods as they address the ball. If we believe that we will earn excess returns by understanding the cyclical nature of markets and their reflexive response to participants’ collective actions, perhaps we can exploit those opportunities more effectively rather than be exploited by them.
When John Burbank from Passport Capital spoke at our iCIO event, the title of his speech was “Price is a Liar,” a concept that George Soros expounds upon when he says, “the generally accepted view is that markets are always right, that is, market prices tend to discount future developments accurately even when it is unclear what those developments are. I start with the opposite view. I believe the market prices are always wrong in the sense that they present a biased view of the future.” The construct here is that in a Reflexive world, where markets tend not toward equilibrium, but toward disequilibrium, the current price of a security is not a reflection of “fair value” as the Efficient Markets Hypothesis would have us believe, but rather a temporary “unfair value” driven by the virtuous, or vicious, cycles created by market participants’ misperceptions and the resulting collective inappropriate actions that come from participants acting on those misperceptions. A perfect example of this phenomenon could be seen at the peak of the equity market in March of 2000 when investors had a collective misperception of the value of technology companies like Microsoft and Cisco (and many other even more outrageously valued names) and investors were willing to pay a price for CSCO shares that in the EMH world were completely logical and reflected the discounted future value of future earnings for Cisco. The Wall Street Journal ran a headline story saying Cisco would be the first $1 trillion market cap company (a feat that still has not been achieved, although Apple is getting closer at $693 billion today) and jubilant investors were happy to pay $286 for every $1 of earnings that Cisco generated in 1999. Just for some perspective on why price is clearly a liar, it would take George Soros nearly 25 years to compound $1 into $286, Buffet would need 29 years and if we had to wait for the average return in the S&P 500, it would take almost 60 years. George Soros was right (as usual) and the CSCO market price was wrong, the tech bubble crashed, investors like Quantum cleaned up being short those companies and today, 15 years later, CSCO stock is still down (65%) from that peak valuation. Cisco’s market cap is only $139 billion (down from the peak of $555 billion) and it is highly unlikely that will ever hit $1 trillion, as Hauwei in China has a different plan on which global company will dominate the network equipment space in the future. To show Reflexivity in action, not one of the 37 Wall Street Analysts at the time had Cisco rated anything lower than a “Buy” or “Strong Buy” (not a “Hold” or “Sell” anywhere to be seen) at the precise peak in the stock, a stock that would then essentially decline nearly in a straight line for the next decade and a half.
George Soros speaks specifically about the challenge of misperceptions when he says, “being aware of Reflexivity, genuinely, I am often overwhelmed by the uncertainties. I'm constantly on watch, being aware of my own misconceptions, being aware that I'm acting on misconceptions and constantly looking to correct them. Misconceptions play a prominent role in my view of the world.” The reality is that we will never have complete information (contrary to conventional Equilibrium Theory); in fact, it is highly unlikely that we will even have a high level of good information at the moment we are faced with the majority of decisions we must make. We are continually surrounded by uncertainty and our brain actually works against us in this regard (just to make things even more challenging). Our brains are constantly bombarded with hundreds of impulses and pieces of information to process; however, the physiology only allows for the processing of seven or eight impulses, so our brain actually increases our distortion/misconception by excluding the bulk of the available information and selectively highlighting and processing the most accessible, most familiar, or most (the worst) closely aligned with our current beliefs. The last part is so dangerous because the way we should create a belief is by gathering all available information, examining it and then deciding. Unfortunately, the human brain does exactly the opposite, it forms the belief and then excludes any information that contradicts that belief, unless we actively override and force the evaluation of alternative views and ideas (explains the preponderance of extreme views on politics, religion and many other areas). Without taking the active approach to not only acknowledge, but to proactively understand and evaluate your misconceptions, as George Soros describes above, it is highly unlikely that you will break free of the cyclical behavior of the herd (which can be extremely harmful to your results as an investor).
So as human beings continually act on their misconceptions, Reflexivity says that those actions then begin to distort the financial markets themselves, which then can actually impact the actual fundamentals of the markets themselves. George Soros says “I contend that financial markets never reflect the underlying reality accurately; they always distort it in some way or another and the distortions find expression in market prices. Those distortions can, occasionally, find ways to affect the fundamentals that market prices are supposed to reflect.” Again we can look to the technology bubbles (2000 and again in 2014) to see how this reflexive pattern works. As the prices of stocks in the technology sector run up, investor perceptions of the potential impact of those technologies (and companies) begins to grow in an exponential fashion. As the mania spreads, more money is attracted to the industry and the price of stocks rises at a rising rate. The ever higher valuations of the companies allows them to do things that actually impact their fundamentals such as acquiring competitors (reducing competition and increasing pricing power) or issuing more equity or debt capital (expanding the resources of the most powerful firms to grow, create new products and services, and increase competitive position). Both of these activities actually lead investors to pay an even higher valuation for those “winners” as the market participants’ perception of the companies rises in a virtuous cycle (enabled by precisely those higher valuations).
George Soros has described how this virtuous cycle can lead to market bubbles, driven by Reflexivity: “stock market bubbles don't grow out of thin air. They have a solid basis in reality, but reality as distorted by a misconception. Every bubble consists of a trend that can be observed in the real world and a misconception relating to that trend. The two elements interact with each other in a reflexive manner.” So let’s go back to our tech bubble example. There is no debating the reality that the technology boom that surged in the late 1990s, when many of the great franchise companies in the technology industry like Microsoft, Cisco and Yahoo boomed, led to a massive surge in productivity, innovation and wealth creation. These companies were selling lots of hardware, software and services to help companies migrate from the Client/Server platform and the future looked very bright for the transition onto this new, new Thing called the Internet. The problem was that the reality of the Internet was indeed bright, but investors’ reality was distorted by the mania surrounding the current dominance of these leading companies and they were willing to pay any price (regardless of fundamental values) to “not miss out.” Investors believed that these companies would remain dominant and they had a misconception that the timeless rules of Capitalism (high profits attract competition) and Creative Destruction (innovation continues and new companies surpass the old leaders) no longer applied. It was another perfect example of Sir John Templeton’s four most dangerous words in investing “This Time It’s Different.” It never is different, and it wasn’t in 2000 (or again in 2014) as the positive trend elicited investor behavior that drove the market to bubble levels, as the reflexive interaction of rising prices and investor enthusiasm created an extreme virtuous cycle (the worst bubble we have ever seen in U.S. equities with P/E ratios in the 40s). In fact, at the peak of the bubble, the market capitalization of those three companies was $1.3 trillion and instead of rushing to sell those ridiculous valuations short, the opposite occurred and a stunning amount of capital, equivalent to 85% of all the money ever invested into technology focused mutual funds up to that point, flooded into the market in the first four months of 2000, rushing to buy, not sell these bubblicious names. As Paul Harvey says, you know “the rest of the story”: the markets peaked and crashed over the next three years; NASDAQ fell close to (80%) and over $5 trillion of wealth was vaporized. Today, the collective market cap of MSFT, CSCO and YHOO is $555 billion, an amazing (60%) decline over fifteen years.
We have written in previous letters about Charles Kinderberger’s seven-year cycle of booms and busts that follow the business/economic cycle, which results from the interplay between “Insiders” (those with the greatest knowledge of companies like owners, management and professional investors) and the “Masses” (those with the least knowledge about companies like retail investors and rules based funds). The Insiders sell assets to the Masses at the top of markets at peak prices and the Masses sell those same assets (at a much lower price) to the Insiders at the bottom of the market. We saw this cycle play out over the seven years from 2000 to 2007 where we run into the next example of Reflexivity writ large. One of the most direct reflections of Reflexivity in the markets that George Soros found in his work was the relationship between credit and collateral. He said, “I made two major discoveries in the course of writing: one is a reflexive connection between credit and collateral, the act of lending can change the value of the collateral, the other is a reflexive relationship between regulators and the economies they regulate.” The housing bubble that was created in the U.S. in the mid-2000s was a case study in how the expansion of credit (Dr. Greenspan encouraging everyone to get bigger mortgages) can reflexively change the value to the collateral being lent against. Housing prices surged ever higher as greater credit availability increased the demand for homes by bringing a greater number of buyers into the market. Only later did it dawn on investors that the incremental buyers were called “Sub-Prime” for a reason and they were not as likely to repay those loans as the Prime borrowers had been historically. Once again, the participants in the market had their reality (prices should rise as demand surges) altered by a misconception that all homebuyers were of equal quality and durability.
George Soros goes on to say that “money values do not simply mirror the state of affairs in the real world; valuation is a positive act that makes an impact on the course of events. Monetary and real phenomena are connected in a reflexive fashion; that is, they influence each other mutually. The reflexive relationship manifests itself most clearly in the use and abuse of credit. It is credit that matters, not money (in other words, monetarism is a false ideology).” As the valuation of homes continued to rise, there was a reflexive response by borrowers to reach for larger homes (prices could only go up, so more opportunity to make huge profits), which further increased the demand for credit. As banks could no longer retain that much risk on their balance sheets, they found ways to securitize the loans and distribute the risk to other market participants. This provision of new securities created another reflexive response in the creation of leveraged pools of these “safe” securities (or so the models said they were safe) and that allowed the banks to further expand their lending activities. Then the second part of the George Soros discovery came into play as the Regulators reflexively relaxed the rules for the creation, distribution and valuation of these securities, leading to increased demand and the virtuous cycle was set into overdrive. Banks could hold unlimited amounts of these securities in the absence of mark-to-market risk and another George Soros quote applies here that “whenever there is a conflict between universal principles and self-interest, selfinterest is likely to prevail.” The universal principle that there should be a relationship between risk of loss and provision of new loans was overridden by the self-interest of originating as many loans as possible to generate high fees, knowing that the risk could be sold to other investors through securitization (creating more fees and more self -interest). In the mad scramble for loan creation during the final phase of the Housing Bubble, the government created an environment of essentially free money by allowing the big agencies, Fannie Mae and Freddie Mac (or Phony and Fraudie, as I often affectionately refer to them) to securitize loans to the bottom of the barrel risks with crazy terms like no money down and incredibly low “teaser” interest rates. George Soros has a comment that applies here as well, “when interest rates are low we have conditions for asset bubbles to develop. When money is free, the rational lender will keep on lending until there is no one else to lend to.” That is exactly what happened, the lenders exhausted the pool of borrowers, the reflexive impact of rising demand pushing prices higher began to wane and the virtuous cycle turned dramatically (as they always do eventually) into a vicious cycle that triggered the Global Financial Crisis and those same banks that made all the ill-advised loans were crushed by massive losses related to the reflexive expansion of credit. Then, yet again, what were Mr. Kindleberger’s “Masses” doing at the peak? Why, of course, they were loading up on index funds, that were loading up on what had run the most (in classic reflexive fashion), the banks and financials, so when Citi and BofA fell (95%) and Phony and Fraudie fell (99%), investors learned, yet again, that price is a liar.
Reflexivity is rooted in uncertainty, and it is that uncertainty which leads to the dramatic misconceptions of market participants who push markets to extremes, resulting in the booms and busts we have all experienced over the years. George Soros has an important belief related to this construct, that “the financial markets generally are unpredictable. So that one has to have different scenarios… The idea that you can actually predict what's going to happen contradicts my way of looking at the market.” They say risk defined more things that CAN happen than WILL happen and he contended that the idea that anyone could consistently pick out which of the myriad outcomes is likely in the financial markets over time was folly. Despite the challenge of divining the future, his investment strategy was not to do nothing (for fear of being wrong). On the contrary, he would acknowledge the uncertainty, as well as his own biases and misconceptions, and boldly make decisions and investments. He states very clearly, “you have got to make decisions even though you know you may be wrong. You can't avoid being wrong, but by being aware of the uncertainties, you're more likely to correct your mistakes than the traditional investor.” He then goes on to explain why it is so hard for most investors to admit when they are wrong, to accept that they have made an error, and to correct the error before it grows into a more costly mistake. I have been fortunate to interact with many of the very best investors in the world, to talk about their investment strategies, and all of them talk about the ability to limit the losses when you make a mistake. George Soros, as always, thinks about the concept with a philosophical perspective, “once we realize that imperfect understanding is the human condition there is no shame in being wrong, only in failing to correct our mistakes.”
Making mistakes as an investor is inevitable, but failing to correct your mistakes is inexcusable and can, in the worst circumstances, be cataclysmic to your wealth. George Soros has also stated very clearly why this concept is perhaps the most important concept in investing in saying “I'm only rich because I know when I'm wrong. I basically have survived by recognizing my mistakes. I very often used to get backaches due to the fact that I was wrong. Whenever you are wrong you have to fight or take flight. When I made the decision, the backache went away.” Being wrong means you are losing money. Losing money means you are eroding the power of compounding, and given George’s amazing long-term track record of compounding, he clearly never stayed in pain very long. You can’t compound at 26.3% (for any period, let alone 41 years) if you don’t recognize your mistakes and take swift and decisive action to correct your errors. Peter Lynch was famous for saying that the best way to make money was to “let your flowers grow and pull your weeds” (another way of saying fix your mistakes). The problem is that most investors do the opposite, they pull their flowers at the first sign of making a profit and they let their weeds grow because they are too proud to admit they are wrong or too stubborn in wanting to show the world that they are right. On the flip side, Stanley Druckenmiller, who worked for George Soros for many years has been quoted often in describing the most valuable lessons he learned from his mentor and said, “I’ve learned many things from him, but perhaps the most significant is that it’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong. The few times that George Soros has ever criticized me was when I was really right on a market and didn’t maximize the opportunity. George Soros has taught me that when you have tremendous conviction on a trade, you have to go for the jugular. It takes courage to be a pig. It takes courage to ride a profit with huge leverage. As far as George Soros is concerned, when you’re right on something, you can’t own enough.” I love so much about this quote because it encapsulates so much investment wisdom and should be a mantra for any investor striving to achieve long-term success. Investing is not about ego; it is not about being right; it is about making money. Great investors don’t care about being wrong — they correct mistakes and move on, they focus on the next play, not the last play. But most importantly, great investors know when they have an edge and they are not afraid to push their position. The difference between poor investors and great investors is “Losers Average Losers” and “Winners Press Winners.” I have written about this before, but every Tiger Cub I have ever talked to has said the same thing about the Big Cat (Julian), “he had an uncanny knack to double, UP.” Another great quote, from Peter T. McIntyre, is applicable here, “confidence comes not from always being right, but from not fearing to be wrong.”
Another unique aspect of the Genius of George is that he was not a “Value Guy” or a “Growth Guy” or an “Activist” or any other label, in fact he says quite emphatically, “my peculiarity is that I don't have a particular style of investing or, more exactly, I try to change my style to fit the conditions.” In the true spirit of Reflexivity, being responsive to the environment and taking advantage of trends when they are trending or capitalizing on distress when it exists has earned George Soros a reputation as simply being a great Investor (with a capital I and no modifier). Given the constant change in the markets, the ability to change your approach to capitalize on those opportunities provides greater upside than investing alongside the masses. George Soros commented on this when he says, “markets are constantly in a state of uncertainty and flux, and money is made by discounting the obvious and betting on the unexpected.” If you do what everyone else is doing, it is unlikely you will make outsized returns. Michael Steinhardt (another Hall of Fame investor) talks about the concept of Variant Perception (a view that is meaningfully different from the consensus) and would agree with George Soros that all his big profits came from investing in unexpected outcomes that turned out to be right. From seeding small managers in Thailand and supersizing their best ideas to giving a manager $500 million after they had lost more than 70% during the Russian GKO Crisis in 1998 (when all the “blue chip” investors were redeeming, yes, George Soros doubled his money in less than a year) to breaking the Bank of England for a cool billion dollar over-night profit, George Soros is an investment chameleon who has thrived on betting on the unexpected and winning. Chameleons change to blend into their surroundings to survive and George Soros has said “if I had to sum up my practical skills, I would use one word: survival. And operating a hedge fund utilized my training in survival to the fullest.” George Soros survived a Nazi occupation of Hungary and a myriad of life struggles in his path to establish a unique investment philosophy rooted in the Darwinian ideal of survival of the fittest (adapt or die) and that philosophy and strategy has produced one of the world’s greatest investment track records.
Bringing the conversation back to Reflexivity, it is interesting to listen to George Soros talk about some of the philosophy and strategy they utilized at Quantum and how they would exploit their understanding of the reflexive process in markets to capture investment opportunities. In describing Soros Fund Management, he said “we try to catch new trends early and in later stages we try to catch trend reversals. Therefore, we tend to stabilize rather than destabilize the market. We are not doing this as a public service. It is our style of making money.” Interestingly, his comment contradicts the conventional wisdom that hedge funds are a destabilizing factor in markets as Reflexivity Theory shows us that it is the markets that trend toward disequilibrium and that organizations like SFM actually help provide stability. It is also interesting that he states very clearly that the goal is to extract economic rents (make money) by capitalizing on the collective errors of the broad market participants following the boom/bust cycles, constantly buying what they wish they would have bought and selling what they are about to need (like those investors selling hedge funds today to chase the hot returns that index funds achieved over past five years). One of my personal favorite George Soros quotes is that “it does not follow that one should always go against the prevailing trend. On the contrary, most of the time the trend prevails; only occasionally are the errors corrected. Most of the time we are punished if we go against the trend. Only at an inflection point are we rewarded.” So often people incorrectly label great investors as contrarians, or vultures, and think they simply lay in wait for some big dislocation and pounce, but George Soros says that the bulk of the returns come from patiently sitting (the Jesse Livermore word again) and riding the trends toward the extremes that are created by the reflexive process in the markets. Most investors miss the majority of the gains available in a trend because they doubt the persistence of Reflexivity and the relative infrequency with which the collective errors are corrected.
Now, precisely because the trends will go to extremes, it is critical to be on the lookout for the inflection points and be ready to reverse your position. George Soros describes it this way, “this line of reasoning leads me to look for the flaw in every investment thesis. I am ahead of the curve. I watch out for telltale signs that a trend may be exhausted. Then I disengage from the herd and look for a different investment thesis.” The continual “Devil’s Advocate” approach maintains a discipline to not fall in love with your own idea or analysis and let the market tell you when it is time to modify your hypothesis. Perhaps it was George Soros’ training in philosophy and his mentorship under Karl Popper that ingrained in him a discipline to continually test his theses and respect the human uncertainty that allows one to be ego-less and move onto the next idea. George Soros describes one of the ways in which you may be able to tell when a trend is exhausted as “short term volatility is greatest at turning points and diminishes as a trend becomes established. By the time all the participants have adjusted, the rules of the game will change again.” Volatility is generated when investors without conviction cannot hold their position as the trend begins to change. The early adopters of a trend are the most knowledgeable and have the greatest time horizon, so they are able to hold through the normal ups and downs that occur in the markets. As the trend matures, the latecomers, who are simply chasing the past performance, have little conviction in the trend and can be easily shaken out when the original investors begin to take profits and move on. That high level of volatility is indeed a telltale sign of turning points (both up and down) in the investment markets. One of the biggest reasons for that is that the bulk of the investment capital is controlled by large institutions and George Soros describes the problem very well in saying “the trouble with institutional investors is that their performance is usually measured relative to their peer group and not by an absolute yardstick. This makes them trend followers by definition.” That trend following behavior exacerbates the reflexive process and leads to higher highs and lower lows, resulting in lower overall returns for the average investor and institutions as a group, but also leads to truly outstanding returns for investors like George Soros who understand Reflexivity and have the discipline to take the other side of these short-term investors’ movements.
The final lesson from George Soros is quite similar to the lesson we wrote about a couple quarters ago in #NotDifferentThisTime on the wisdom of Sir John Templeton who said that investors would always ask him where is the best place to invest and he would respond to them that this was exactly the wrong question and that they should rather be asking where is it the most miserable? Investing where things are good and comfortable will consistently yield mediocre returns; not bad returns, just not great returns. I have often said that if you make in investment and you feel OK, you will make OK returns, if you feel good, you will likely lose money, and if you felt a little queasy, you will likely make money. George Soros says it a little bit differently in that “the worse a situation becomes, the less it takes to turn it around, and the bigger the upside.” His view is perfectly aligned with Sir John, or with Arjun Divecha at GMO who says “you make the most money when things go from truly awful to merely bad.” George Soros’ point is that once things get really bad and the reflexive process has driven the trend to the extreme, the slightest change in perception can turn the tide and the bigger the move will be on the other side.
George Soros does add a couple qualifiers here in saying that “unfortunately, the more complex the system, the greater the room for error. The hardest thing to judge is what level of risk is safe.” The markets are huge complex adaptive systems (that tend toward extremes of disequilibrium thanks to Reflexivity) and the complexity has been rising at an ever-increasing pace with globalization, financialization, securitization, Central Bank intervention and the increase in speed of everything from information dissemination to trading. Higher complexity means greater risk of errors and higher costs for those errors, so the most challenging thing to determine, according to Soros, is what level of risk is appropriate for investors to take. What these final thoughts seem to say quite loudly is that in an increasingly complex investment world, risk management and mitigation are paramount, that the ability to admit when you are wrong on a position and exit with a small loss is critical, that the necessity to maintain focus in areas of strength and expertise and not stray into unfamiliar territory is crucial and that understanding how the construct of Reflexivity can help us structure positions more effectively to capitalize on investment trends and take advantage of market dislocations. We believe that heeding the lessons highlighted above can help all of us spend more time enjoying the “virtuous” and less time being punished by the “vicious”.