THEORY OF REFLEXIVITY

The theory of Reflexivity propounded by George Soros, seeks to demonstrate that financial markets cannot discount the future correctly because, in certain cases, the behaviour of financial markets affect the so called fundamentals which they are supposed to reflect. It implies that financial markets do not merely discount the future; they help to shape it.

Therefore reflexivity is a self fulfilling prophecy which occurs when markets react to the expectations of its participants. A feedback loop occurs, wherein prices are driven by perceptions and the movement of prices help to reinforce expectations.

Consider the example of the Indian stock markets after its all time high in January, 2008. Once the markets started falling from its highs, investors, particularly FII' withdrew from the markets in large numbers. This caused stock prices to fall further. The fall in prices led to a perception among investors that markets were overheated. This in turn led to further selling in the markets, thus creating a feedback loop, where the prices were affected by investors' negative perceptions, which were in turn reinforced by falling market prices.

This selling and absence of fresh inflows by FII' led to the Rupee weakening against the Dollar, which resulted in inflation rising and interest rates going up. As a consequence, profitability of companies, which was projected to grow at 20 % on an average, started slowing down. Though not the only reason for slowing growth numbers, this example serves to illustrate how markets can influence fundamentals.

Soros contends that, "such boom/bust sequences do not arise very often, but when they do, they can be very disruptive, exactly because they affect the fundamentals of the economy." Conventional market theory acknowledges that all the available information is built into prices and current markets correctly discount the future. Soros thinks that this interpretation of the way markets operate is severely distorted . He works on the principle that whenever he takes a position, he does not automatically presume that the markets are wrong, but allows for the fact that he himself could be wrong on his call.

This article relies heavily on a speech made by George Soros on April 26, 1994 to the MIT Department of Economics World Economy Laboratory Conference Washington, D.C.