Saturday, August 18, 2012

Alchemy of Finance by George Soros

Note:This article is compiled from 'Alchemy of Finance' by George Soros.

As an undergraduate Soros read at LSE and read science , philosophy and also came across economics but he realized that it lacks objectivity also it is a science but it does not come in contact with scientific methods. Later at LSE while studying Philosophy under Karl Popper he came across the study of "Scientific Methods" and this fascinated him.The model of "Theory of Reflexitivity" is based on Popper's ideas.Sir Karl Popper also considered how new observations affected knowledge - such as spotting a black swan when it was thought all swans were white. Facts to perception and perception to facts is which gets to knowledge but unfortunately the perception of elements does not lead us to facts or truth so uncertainty is always involved. Being the son of a war survivor Soros learned to struggle in complex time in world war II.

Soros later scored a post as a market trader first in London and then New York.He became securities analyst and ruled as one eyed King among blind .He started to model portfolios and then made a fund which was later called as a hedge fund.He made it to 2 Billion and was able to give 300% results and no other fund gave such high return.He discovered that financial markets work on Scientific method and that risk is involved and the exact perception and method is what gives you return and result and always overcoming the error or uncertainty is what you need to calculate. Testing and success is always common in markets and only right method gives you accurate result. 

Operating a hedge fund is all about risk and right leverage ,Soros did not play financial markets but was rather interested in randomness of markets and things that cause jumps in markets and how to predict it.He used "Theory of Reflexitivity"  in hedge funds and theory of debts, the more he studied about the changes in markets the more theoretical he became and I published many papers.Stock market and credit cycle have boom and bust and market crashes, reflexive connection between credits and stocks were subject of his publications. Classical economics deals with real world and neglects the problems with banking system. Inflation is controlled by money supply but this only happens in classical economics but not in financial system.

Soros states that monetary economics fails in boom and bust of financial markets , credit cycle in banks does not follow Keynesian markets anymore but rather in economics outside banking system.Supply-demand curve fail to reach equilibrium in financial markets , in financial markets the supply-demand curves are themselves dependent on the market developments and trends, so instead of reaching equilibrium we get fluctuations.Thus using Classical economics will lead to errors.Finding equilibrium is what needs to be understood and that why equilibrium is never achieved .Distortion is there even with the presence of logic and maths of finance due to factors like randomness and absence of knowledge and hypotheses etc.Equilibrium is reached when marginal cost equals market price and that equilibrium is optimal point for both supplier and customer. Perfect knowledge , large number of participants and other conditions make perfect market and that  equilibrium is reached at optimal level but in real world this is not possible as the invent of stocks , bond market and other complex financial instruments have made the financial market a complex place where perfect market condition is not achieved .
George Soros, the chairman of Soros Fund Management.

Soros believed that financial markets do not tend towards equilibrium, as conventional theory would argue. Rather, they feed on their own misconceptions about events to produce exaggerated movements, which produce new misperceptions.This two-way feedback between perception and reality Soros describes as his theory of reflexivity.Soros’ Theory of Reflexivity is a fascinating economic maxim derived from investor’s perceptions of the economic market place and market values and our forgetting to include what our own impact on the market is.It is, he claims, something that the shrewd investor can exploit by following the trend till it reaches the peak, and then, identifying what Soros calls the 'inflection point', switch to the opposite tack. The concept of an inflection point is perhaps not new, but simply a renaming of the concept of a sharp upward or downward spike in the market. Rising prices and speculations attract demand and trends vary and so supply and demand is always on the move. Another factor is participant's thinking which alters demand and other factors , economists and scientists do not take account of participant's thinking and this factor cannot be measured by them. Participant's thinking and biasness is measured by "Behavioural Finance" experts , this field recently got growth  by few academics .

 Equilibrium vs. Reflexivity

Stock markets are the markets which have "perfect competition" in them as it has large crowd, homogenous products and access to information is there and no other market is closer to perfect market than stock market and thus Soros was able to use theory of reflexivity in it. Theory of reflexivity can be tested for the economic equilibrium in stock markets, equilibrium price chase using my reflexivity theory was later my passion .Changes in condition give rise to changes in stock markets , random walk theory recently came for getting the speculation of stocks. 

Technical analysis studies market trends using past data ,uses of methods to calculate future from past data is common in this analysis and calculation of probability is used as well.  Fundamental analysis is more theoretical and in it Earning and Price of stocks is taken into account , company's "Price and Earnings"  are taken into account for predicting stock price. Company's earnings and fortunes and vale of stocks are directly proportional. High earnings of stocks of company give company a better fortune and better rating and so this is taken into account of value of stocks in future. Price/earnings of company is what is the taken into account of its stock in Fundamental Analysis.

Stocks prices are also determined by bias of participants , other factors are there as well that influence the price of stocks. Stock prices itself change bias of participants and also trends change thinking and bias of participants. As there is no constant involved so we cannot reach equilibrium. Reflexivity theory is thus developed to relate trend of stocks , price of stocks and also the bias and thinking of participants.

Perception of participant can never be studied and measured even with the help of top psychologists as there are several factors involved and price/trends of stocks is only one factor. Market participants are not given the exact picture as always there are several errors in information and some information is missing , price-earnings data and trends do not give perfect picture as always this will not give a perfect picture. Stock prices reflect few factors of markets but there are few factors which are missing and also some errors are still there. Real Estate is also a market with high boom and busts , Sub-prime crisis of 2007 is one example. As real estate market used to give a lot of profit as so investment was common in it but because of some flaws Sub-prime crisis happened. Defence spending which started in 1920s as war was predictable and so defence stocks were high and good investment. Also with Rise of Google and Microsoft the stocks rose and thus investors made use of it. Apple got bust and so its stocks fell and recently Apple stocks fetch high price.
Soros is known as "The Man Who Broke the Bank of England" because of his US$1 billion in investment profits during the 1992 Black Wednesday UK currency crisis.

Market tends towards equilibrium and speculation does not disrupt the trends rather right speculation accelerate the trend of market. Exchange rates influence Fundamentals (Fundamentals are factors that are studied in Fundamental Analysis) like Price - Earnings or Inflation. In stock markets the stock prices are taken into account for speculation but dividends are ignored. Fluctuation in exchange rates depends on high returns, volatility thus also depends on the high returns and stock prices, fluctuation becomes so wild that Government intervention is necessary.

Speculation in currencies is a risky business as well , one cannot earn steadily. Trends are followed by few investors while some use the speculation against the dollar. Active lending makes financial market active and allows lender to invest and consume more products which he/she would not have done without the lent money. Trade and credit cycle differ a lot in trends and in textbooks you will not find the exact movements of books and they are different then the trends in real market. When economy is less regulated the markets are more prone to fluctuations and also the regulatory cycle is controlled by economists and who are not prone to credit patterns in financial markets and thus a not so efficient regulation will make credit cycle more turbulent. Banking industry's complex behavior in last few decades has led the Government to  regulate it . 

Ability to forecast financial events causes one to make profit, successful methods are never fixed and that with experience one keeps avoiding the failures of prediction but no one is perfect in this business. A market trend whenever I followed  made me model a hypothesis but before I could practise it the trend changed and giving me disappointment and I was always lagging behind. Conjectures about future did disappoint me a lot but whenever my conjectures proved right I made huge returns. 

Real world events carry a lot of impact on financial market, best example is of Microsoft or even Apple . Oil prices changes stock prices a lot, wars and other changes in country's economy fluctuates the financial markets a lot. Stock market predicted seven recessions in the past while world events cannot predict the impact or the degree of impact on financial market. The previously successful hedge fund Long Term Capital Management (LTCM) was driven into the ground as a result of the ripple effect caused by the Russian government's debt default. The Russian government's default represents a Black Swan event because none of LTCM's computer models could have predicted this event and its subsequent effects and thus came the 2007-2008 crash. Concept of equilibrium is a bridge between social and scientific methods and only in equilibrium gives right prices so social events and scientific events and other disasters all needs to be speculated and risk should be measured in correct way and thus we  get the right solution. Human errors cannot be corrected and so there is always some error left even we fix every social and scientific method.