The Man who broke the Bank of England: A Philosophic and Economic Tale of Success in Financial Markets
George Soros, the man who ‘broke’ the Bank of England, speculated correctly against the short-sale of the Pound in 1992 as well as the East Asian devaluations in 1997. His Quantum fund compounded at a phenomenal rate of 20% annually and he is presently one of the richest men in the world. His contrarian, then anti-contrarian and irrational market views have shone light on perceived deficiencies in the Efficient Market Hypothesis(EMH) and the Capital Asset Pricing Model. In retrospect, The Alchemy of Finance is a book ahead of its time and has some relevance, still today. It was written in the right place and at the right time; where Economics and Finance disciplines meet a memoir of Philosophy and Behavioural Finance.
Soros fled Hungary to study Philosophy in London. After completing his studies in London, Soros ended up in New York as an arbitrage trader. Soros was always curious about how the economic world functioned and how philosophy could be used to explain the overlap between theory and real world outcomes, which the economic discipline failed to explain. As an admirer of Keynes and Smith, Soros had always envisioned that, like these ‘greats’, he too may one day become a famous philosopher. After turning back to his philosophical ideas, Soros got lost in the intricacies of his own discovery: the concept of Reflexivity. He wrote substantially on Reflexivity but later abandoned his philosophical ambitions to pursue making money as a hedge fund manager. His understanding of philosophy coupled with his arbitrage trading experience allowed him insight into the functioning of market participant’s behaviour which Soros applied to his business and philanthropic activities. Soros’ insights allowed him to both predict events before they occurred as well as explain events after they had occurred.
In this book, Soros explains his ideas, methods and philosophy which have made him billions with his successful market bets. One need not look further than his current net worth of USD 24.6bn (March 2016) to prove his success. Soros’ book helps to crystallize a number of questions that one may have had about the EMH, information asymmetries and how to profit in a world considered to have ‘perfect information’. Furthermore, Soros alludes to how orthodox economics falls short of what actually happens in the world, highlighting a fundamental weakness of Economics: that it is merely a theoretical construct of reality.
First published in 1987, Soros introduces his Reflexivity framework which he uses to explain and validate historical events (ranging from the World War, the collapse of the Bretton Woods System and the rise of Conglomeration); he documents his real-time investment decisions (both positive and negative bets), evaluations and suggest potential applications.
The Alchemy of Finance, uses a formal writing style coupled with Soros’ experiences to convey its message in a way that only someone with prior philosophical, financial and economic knowledge would understand. For this reason the concepts can be complex at times especially the concept of Reflexivity. Soros has the very difficult task in explaining the phenomenon of Reflexivity in an understandable manner using key concepts and examples.
The title of the book is interesting and alluring in its own sense. The word “Alchemy” is a form of chemistry, a pseudo-science (associated with the 1600s) principally concerned with discovering methods for transmuting a common substance, usually of little value, into a substance of great value i.e. changing the nature of metals, for example, changing lead into gold. The Alchemy of Finance, is a smart title for this topic which constantly reminds the reader of Soros’ intentions of contrasting economics with that of alchemy.
Soros is majorly influenced by studying the philosopher, Popper. He takes parts of Poppers’ Scientific Method and infuses this with his views of the economic world. The concept of Reflexivity is the relationship between thinking and reality. This concept utilises the Principle of fallibility: where information is partial and incomplete and therefore, leads to distortions. Reflexivity is the process of applying the principle of fallibility and how these distorted views can influence economic agents’ decisions. This is due to false views leading to inappropriate actions by market agents. Even though this is common sense, Soros mentions that it is deeply ignored in the economic discipline. This is due to the fact that the economic pedagogy in Soros’ view, has been taught on a false premise: economic theory is built on an abstract-arbitrary ‘equilibrium’ state which is directly in contrast to reality and is thus reflexive in nature.
The concept of human irrationality is proven in studies of brain science whereby emotions lead to distortions; distortions which cannot be avoided. The world is inherently imperfect due to the thinking process of economic participants. There is a slippage between an agent’s intentions and their actions and a further slippage between an agent’s actions and their desired outcomes. Therefore, there is an element of uncertainty in our understanding and in the ability to create universally applicable economic laws and outcomes.
Boom and bust cycles/bubbles are characteristics of financial markets and the by-product of extreme misjudgement, which are ultimately driven by emotional cognitive processes. Soros posits this very abstract concept and compares it to physical sciences where the ability to measure empirically cannot be done in the same way for the Economics discipline.
Soros briefly mentions the history of economic thought and how rational expectation is an absurd concept modelled on a ‘physics’ equilibrium – which is observable in nature. Natural science laws and empiricism cannot be compared to economic science (social science). This is a dichotomy which aims to make a science out of a confusing reality. Social science theory is of a reflexive/subjective nature rather than an objective one as espoused by science. The underlying assumption of “rational behaviour” which underpins economics resembles a single criterion which natural science would possibly use, yet this criterion does not exist in reality. Economics as a science, therefore, creates a theoretical equilibrium which is beyond reach: a moving target.
Soros recognised that, classical economists focused on the real world yet neglected the problem of money and credit whilst the monetarists focused on controlling the growth in the money supply. Soros saw all of these economic ways of viewing cause and effect being based on a fundamental flaw. Asset valuations are of a monetary value and do not mirror the state of affairs in the real world as these variables are connected in a reflexive relationship: they impact each other mutually, in circularity. Soros successfully used his theory of reflexivity to profit from exchange rates regime changes, international debt discrepancies and conglomeration.
We can, to a certain degree, predict nature as it’s not as uncertain as the behaviour of individuals. Economic generalisations, on the other hand, cannot be properly tested by the same method as that of the laws of physics. This is what famous psychologist Freud refers to as ‘Physics envy’, the process of social scientists (Economists) using a sort of wishful thinking to believe that a participants “thinking” leads to a particular “action” and hence an “output” – much like a computer which has inputs and outputs. Human beings are not entirely “rational” and sometimes rather it is our cognitive biases that drive us and hence, irrational stock market outcomes.
The overall theme in The Alchemy of Finance is that market participants operate with perceptional bias which alters the true equilibrium constantly. Soros noticed a practical versus theoretical misalignment and holds an inverse view that markets are always wrong due to inherently flawed perceptions.
Perfect information does not necessarily mean perfect knowledge. Market participants’ objective reasoning is skewed, due to cognitive thought processes and emotions; this fundamental base of Reflexivity results in markets being mispriced continuously. The continuous economic equilibrium state is an assumption that is merely disguised as a methodical device/approach. Economics as a social science cannot be transmuted (as lead be changed into gold) into a physical science. Economics is not a universally applicable theory; the laws of nature are. Soros tested his hypothesis and leveraged-off of extremities in market value. He understood that markets are not correct as market participant’s judgement is biased due to cognitive ‘noise’ resulting in imperfect outcomes.
I found this book partly relevant even today. The Global Financial Crisis is another scenario in which agents’ judgements had been skewed and resulted in excessive, unsustainable market prices. This resulted in the boom/bust cycle as mentioned by Soros.
To critique Soros, various other techniques have been used to outperform the markets. Perhaps, Soros is a one-of-a-kind and his theory cannot be successfully replicated which casts doubt on its applicability. In its purest form, the Alchemy of Finance adds insight but since the book has been written, market competition has increased, resulting in diminishing returns and narrowing the outperformer gap: the rules of the finance game have changed.
Indexing, passive strategies, contrarianism, fundamentalism and technical analysis are all other strategies that can be successfully employed alone or in combination which makes his finance memoir a bit one-sided and perhaps even pointless.
At times, some concepts that Soros imparts, needs to be read twice, as he speaks on an abstract level and with prior philosophical context which some readers may not have. Overall, I would recommend this as an undergraduate compulsory read as it enlightens those bound to the rules of orthodox economic literature and conventions. Soros takes the path less travelled and challenges the abstract mind in a way that leads us to understand the fundamental reasoning of the market system and the human decision-making process.
I have learnt that in order to become a great mind, constant questioning of conventional wisdom is required in combination with academic fields and literature that goes beyond the realms of one’s own field of specialisation.