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Theory of Reflexivity

Theory of Reflexivity

George Soros’ Theory of Reflexivity simply states that investors don't base their decisions on reality, but rather on their perceptions of reality. The theory of reflexivity has its roots in sociology, but in the world of economics and finance, its primary proponent is world-famous investor George Soros. His theory of reflexivity runs counter to the concepts of economic equilibrium, rational expectations, and the efficient market hypothesis. According to him, investors base their decisions more on how they perceive reality than on reality. As a result, there is a self-fulfilling loop in which traders’ views affect the underlying principles of economic activity, impacting traders’ perceptions. At its core, reflexivity proposes that subjective perception and objective reality interact in a dynamic feedback loop, especially in systems involving thinking participants—such as humans in financial markets, politics, or society at large.

THEORY OF REFLEXIVITY

  • The Theory of Reflexivity is a concept primarily applied in economics, finance, and social sciences.

  • The theory is well-positioned to explain the boom-and-bust pattern that has played out throughout history in asset prices.

  • It challenges the traditional assumption that markets (and social systems in general) move toward equilibrium based purely on rational expectations and objective realities.

  • It is based on the idea that feedback loops between expectations and economic fundamentals can cause price changes that substantially and persistently deviate from equilibrium prices.


EXAMPLE IN FINANCIAL MARKETS

2008 Financial Crisis

  • Belief: Housing prices always rise.

  • Action: Risky lending, mortgage securitization.

  • Feedback: Rising prices reinforced belief → bubble.

  • Outcome: Belief collapsed → crash.

Dot-Com Bubble (2000)

  • Belief: Internet companies are the future.

  • Action: Overinvestment in unprofitable tech firms.

  • Feedback: Skyrocketing stock prices drew in more investors.

  • Outcome: Valuations crashed when profits didn’t follow.

Black Wednesday (1992)

  • Belief: UK can’t maintain its currency peg.

  • Action: Massive shorting by speculators.

  • Feedback: Bank of England couldn’t defend the pound.

  • Outcome: UK exited ERM, pound collapsed, Soros profited.

Bitcoin & Crypto Booms

  • Belief: Crypto is the future, prices will rise.

  • Action: Herd buying, media hype.

  • Feedback: Prices rise → more belief → more buying.

  • Outcome: Volatility and major crashes after sentiment shifts.

GameStop / Meme Stocks (2021)

  • Belief: Retail traders can outplay institutions.

  • Action: Coordinated buying caused a short squeeze.

  • Feedback: Price surged, attracting more buyers.

  • Outcome: Eventually crashed as momentum faded and platforms restricted trades.

Warnings and Disclaimers

The information contained herein is obtained from sources believed to be reliable, but its accuracy cannot be guaranteed. It is not designed to meet your personal financial situation - we are not investment advisors nor do we give personalized investment advice. The opinions expressed herein are those of the publisher and are subject to change without notice. It may become outdated an there is no obligation to update any such information.

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