Reflexivity has its origins in social theory, where it referred to circular relationships between cause and effect. The concept was expanded to science in general by Karl Popper – Soros’s old philosophy professor in London. Soros in turn applied it to economics and finance, discussing this in depth in his 1987 book The Alchemy of Finance. The idea is that investors base decisions on their perceptions of reality rather than on reality itself. Their subsequent actions, however, do have an impact on realities such as economic fundamentals, which leads to a shift in investors' perceptions and thus investments’ prices. Soros credits much of his success to his understanding and application of reflexivity to financial markets 🔁

A bank run is a classic example of reflexivity in action. Let’s say customers of Bogus Bank believe, for whatever reason, that it’s in a weak financial position. They start withdrawing deposits in case the bank ends up unable to pay out. Even though Bogus is actually in a solid financial position, a large enough number of people pulling their money could push the bank into insolvency. The heightened fear of that happening prompts yet more withdrawals – until, in a self-fulfilling prophecy, Bogus Bank does indeed go bankrupt. This is an example of how perceptions can impact economic fundamentals.

Reflexivity can help explain the cycle of economic booms and busts. In fact, Soros used the theory to predict the 2008 financial crisis and Quantum was one of the few hedge funds that made money that year. The big issue with self-reinforcing feedback loops in investing is that market prices can become increasingly detached from economic reality. In the lead-up to 2008, would-be homeowners thought property prices would go up forever. Their purchases did in fact drive up real estate prices, which led to more mortgage lending by banks – fueling yet higher prices. Eventually, however, the bubble burst, forming one of the main causes of the crisis and resulting recession 😣