Earlier, we looked at a talk given by legendary macro-investor George Soros (Trades, Portfolio) at Central European University back in 2009. He introduced his investment philosophy by contrasting it with the efficient market hypothesis, which states that the price of a security reflects all available information, and that price action cannot affect the underlying fundamentals of that security. Soros believes that changes in stock prices can influence how real-world events are perceived and valued, a phenomenon he refers to as reflexivity. Here are some examples of this.
Real estate booms
āThe simplest case [of reflexivity] is a real estate boom. The trend that precipitates it is that credit becomes cheaper and more easily available. The misconception is that the value of the collateral is independent of the availability of credit. As a matter of fact, the relationship between the availability of credit and the value of the collateral is reflexive.
When credit becomes cheaper and more easily available, activity picks up and real estate values rise. There are fewer defaults, credit performance improves and lending standards are relaxed. So at the height of the boom, the amount of credit involved is at its maximum, and a reversal precipitates forced liquidation, depressing real estate prices.ā
In efficient market theory, the current state of the real estate market should not affect whether an individual borrower receives a mortgage. In this conception, the price of a house is always a reflection of its real intrinsic value. In practice, we know this is not true. In boom times, when the value of real estate is rising, more and more borrowers are able to access credit on increasingly favorable terms. This in turn drives valuations even higher, which again fuels access to even cheaper credit, perpetuating the cycle further until it is unable to run any further.
Sovereign debt
āThe international banking crisis of 1982 revolved around sovereign debt, where no collateral is involved. The creditworthiness of sovereign borrowers was measured by various debt ratios, like debt-to-GDP and debt service-to-exports. These ratios were considered objective criteria, when in fact they were reflexive.ā
If your assessment of how creditworthy a person or institution is related to their ability to access credit in the first place, that is obviously a cyclical situation. Valuation is supposed to be based on objective criteria, but in practice, the price of a security can affect its intrinsic value. Although much of what Soros believes is similar to the value investing philosophies of people like Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio), it is this additional insight that makes him so interesting as a thinker.
āWhen Alan Greenspan spoke of āirrational exuberanceā in 1996, it misrepresented bubbles. When I see a bubble forming, I rush in to buy, adding fuel to the fire. Thatās not irrational. And thatās why we need regulators to counteract the market, when a bubble is threatening to grow too big, because we canāt rely on market participants, however well-informed and rational they are.ā
In other words, buying an asset that is rising in price isnāt necessarily irrational for an individual investor who has a good handle on when the bubble might run out of steam. But it is bad for the system as a whole, which is why Soros believes regulators have to step in to control human excess.
Read more here:
- George Sorosā Investment Philosophy, Part 1
- The WeWork IPO Looks Finished
- Bruce Flatt on His Investment Philosophy and Mistakes
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