George Soros' Investment Philosophy, Part 1

Nowadays, you are likely to hear George Soros (Trades, Portfolio)’s name mentioned in a debate over the various political causes he has supported over the years. Depending on your persuasion, Soros is either a principled philanthropist spending his wealth to do good, or an evil mastermind hell-bent on undermining national sovereignty.

That is not a can of worms I want to open today. Instead, I want to focus on his record as an investor, which has undeniably been spectacular. Between 1970 and 2011, his Quantum Fund went from $12 million in assets under management to $25 billion. In this 2009 talk at Central European University, Soros explained some of the principles behind his investment philosophy.

Feedback loops

Soros began by stating his two guiding principles:

“First, market prices always distort the underlying fundamentals. The degree of distortion may vary, from the negligible to the significant. This is in direct contradiction to the efficient market hypothesis, which maintains that market prices accurately reflect all the available information. Second, instead of playing a purely passive role in reflecting an underlying reality, financial markets also have an active role. They can affect the so-called ‘fundamentals’ that they are supposed to reflect.”

In addition to assuming the price of a security always reflects all available information, the efficient market hypothesis assumes the connection between fundamentals and price is unidirectional - whatever happens in the underlying business will affect the price of the stock, and that’s it. Soros’ insight was that price action can affect the underlying fundamentals too. He calls this phenomenon a "reflexive feedback loop," drawing on the work of philosopher Karl Popper (his tutor at the London School of Economics, who developed the idea of reflexivity more generally).

He distinguished between two types of feedback loops: negative and positive. Negative loops are self-correcting, whereas positive ones are self-reinforcing and naturally trend toward disequilibrium. Here’s what this means when applied to stock market bubbles:

“Every bubble has two components: an underlying trend that prevails in reality, and a misconception relating to that trend. A boom-bust process is set in motion when a trend and a misconception positively reinforce each other. The process is liable to be tested by negative feedback along the way. If the trend is strong enough to survive the test, both the trend and the misconception will be further reinforced. Eventually, market expectations become so far removed from reality that people are forced to recognize that a misconception is involved. A twilight period ensues, during which doubts grow and more people lose faith, but the prevailing trend is sustained by inertia...Eventually, a point is reached where the trend is reversed, and it becomes self-reinforcing in the opposite direction.”

To illustrate this somewhat academic point, Soros used the example of the conglomerate boom of the late 1960s. During this period, the conglomerates showed a real increase in their earnings per share, primarily by acquiring other companies. This was the underlying trend. Their share prices were the expectations that related to the underlying trend. While share prices were high, the conglomerates were able to keep acquiring more companies, thus improving earnings per share. This is a prime example of price action affecting fundamentals. Eventually, though, expectations got too high and the bubble burst. Once share prices fell, all the problems that had been wilfully overlooked came to the fore.

This pattern has repeated across many different time periods and asset classes, though the exact timing of events differed. Studying financial history is invaluable because it shows you that humans always act in basically the same ways, regardless of how advanced we think we have gotten. In the next part of this series on Soros, we will examine other forms of reflexivity in the markets.

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