[00:02:52] Shawn O’Malley: And in 1945, he survived the siege of Budapest, where German and Soviet forces fought house to house throughout the city. Soros moved to the United Kingdom in 1947, where he studied at the London School of Economics, and then received master’s degrees in both science and philosophy. During that time, he became particularly fond of the philosopher Karl Popper, who tutored him.

[00:03:15] Shawn O’Malley: He spent the next few years working at banks before setting up his hedge fund, which would later be renamed the Quantum Fund after the theory of quantum mechanics. In a 2006 interview, a reporter asked him, quote, How does one go from an immigrant to a financier? When did you realize that you knew how to make money?

[00:03:32] Shawn O’Malley: Soros replied, Well, I had a variety of jobs and I ended up selling fancy goods on the seaside at souvenir shops, and I thought that’s really not what I was cut out to do. So I wrote to every managing director in every merchant bank in London, got just one or two replies, and eventually that’s how I got a job in a merchant bank.

[00:03:51] Shawn O’Malley: From the Quantum Fund’s start, Soros grew the fund to 12 million in assets under management to 25 billion by 2011. His fund had some incredible talent working there, with famed investors like Jim Rogers, Stanley Druckenmiller, Mark Schwartz, and Keith Anderson all having worked with Soros at Quantum. In 2008, Soros was inducted into the Hedge Fund Manager Hall of Fame alongside greats like Jim Simons, David Swenson, Paul Tudor Jones, Seth Klarman, and Steve Cohen.

[00:04:20] Shawn O’Malley: As of 2014, Soros was listed as having created more total wealth for investors in his hedge fund than any hedge fund ever, generating almost 42 billion in gains since 1973. He was also selected as the Financial Times Person of the Year in 2018. In markets, Soros is most famous for being the man who broke the Bank of England.

[00:04:41] Shawn O’Malley: During a financial crisis in 1992, the UK government was forced to pivot away from holding the pound’s exchange rate in a fixed range. Pressured to do so, in part, came from Soros and other traders accumulating huge, short positions that would profit if the pound’s value fell below the government’s target range.

[00:04:58] Shawn O’Malley: Previously, the UK had agreed to join a system called the European Exchange Rate Mechanism, where the pound would have fixed exchange rates with the German mark. Established in 1979, this plan hoped to stabilize the exchange rates between European currencies, enabling countries to eventually adopt a common currency, which we now know as the Euro.

[00:05:17] Shawn O’Malley: Germany’s currency was considered the strongest and most stable in Europe. And countries adhering to the exchange rate mechanism had to intervene in currency markets to keep their currency’s exchange rates within the defined upper and lower limits. After initially declining to join, the UK, under the leadership of Prime Minister Margaret Thatcher, agreed to peg its currency to the German mark as part of a commitment to more deeply integrating the country into European markets.

[00:05:41] Shawn O’Malley: Doing so was not without problems though. Firstly, the UK’s timing couldn’t have been much worse. They agreed to a relatively high exchange rate against the mark that would make the pound more expensive when trading with the rest of the world, leaving the country’s exports less competitive and hurting economic growth.

[00:05:56] Shawn O’Malley: Secondly, because Britain faced higher inflation than Germany, it had to keep interest rates considerably higher to help keep its exchange rate in line with the and those higher interest rates further suppress growth. This, among other political uncertainty facing the UK and plans to create a single currency in Europe, made Soros and other traders skeptical that the UK could maintain its peg against the mark for any extended period of time.

[00:06:19] Shawn O’Malley: In other words, the UK’s central bank, the Bank of England, was in a war against market forces, hoping to shelter the pound from natural fluctuations, and hedge fund managers like Soros were betting that market forces would prevail. Soros was so confident in fact that he bet over 10 billion dollars on the depreciation of the pound as he shorted the currency.

[00:06:38] Shawn O’Malley: With the quantum fund, Soros borrowed billions of pounds from various banks and sold them for other currencies like the US dollar and German mark. When the pound depreciated against those currencies, he could convert those dollars and marks back into pounds at a more favorable exchange rate, leaving him with leftover profits after paying back the borrowed money.

[00:06:56] Shawn O’Malley: Soros bets were so large that, along with other positions betting against the pound using options and futures, he almost single handedly dragged down the pound’s exchange rate to below its target with the mark, forcing the Bank of England to eventually abandon its fixed exchange rate policy. Of course, British governmental officials and the Bank of England didn’t give up without a fight.

[00:07:17] Shawn O’Malley: They sought to stabilize the pound’s exchange value by aggressively raising interest rates from 10 percent to as high as 15 percent in short succession, hoping that the higher rates would attract investors overseas to buy pounds and earn more interest with their deposits than they could just about anywhere else in the world.

[00:07:34] Shawn O’Malley: They also drained the country’s foreign exchange reserves, spending billions on buying back their own currency in the open market by selling their holdings of other nations currencies that were acquired from trade. All this only made market speculators even more certain that the government couldn’t hold the fixed exchange rate without destroying their own economy via abnormally high interest rates.

[00:07:53] Shawn O’Malley: Even German officials were trying to help behind the scenes, but it was just too little too late. On Black Wednesday, as it’s known, in September 1992, everything came to a head. The pound plunged by 15 percent against the mark, and 25 percent against the dollar, which is just an unimaginable move for a major currency to make.

[00:08:11] Shawn O’Malley: A 25 percent drop is a huge move for even the riskiest stocks to make in a single day, let alone the currency that an entire developed nation’s economy saves in. It was a humiliating defeat for Britain’s government, the credibility of its institutions and financial system, and really marked a loss of faith in the pound itself.

[00:08:30] Shawn O’Malley: Unfortunately, those weren’t just numbers bouncing around on a screen. The pound’s depreciation had considerable economic effects, fueling social unrest as unemployment and inflation surged. The long term implications of this saga are still with us today, too. While the Euro did launch in 1999 as the common currency for the Eurozone, I don’t think it’s a stretch to say that Black Wednesday and George Soros played a significant role in the UK’s decision not to embrace the Euro and to instead continue using its own currency.

[00:08:58] Shawn O’Malley: It’s really a fascinating episode in financial history and a defining moment in Soros reputation. After this, people usually saw him in very different lights. He either embodied everything wrong with Wall Street, or he embodied everything wrong with governments for thinking they could devise a system that was so at odds with market forces.

[00:09:16] Shawn O’Malley: Both are obviously biased portrayals of how things went down and his motives for betting against the pound, but you can see from this alone why he has had such a divisive effect on people. In 1999, the economist Paul Krugman was one such leading and critical voice against Soros. He said, quote, nobody who has read a business magazine in the last few years can be unaware that these days there really are investors who not only move money in anticipation of a currency crisis, but actually do their best to trigger that crisis for fun and profit.

[00:09:46] Shawn O’Malley: These new actors in the scene do not yet have a standard name. My proposed term is Sorowai. So successfully shorting the pound was obviously Soros claim to fame as an investor, but there’s a whole lot more to learn from him than just knowing how that trade unfolded. More interesting is Soros general theory of reflexivity for financial markets, which he’s used throughout his career.

[00:10:08] Shawn O’Malley: In short, reflexivity suggests that market prices are typically driven by participants fallible ideas beyond just economic fundamentals. It implies a circular cause and effect dynamic in markets. People’s ideas about markets and events in markets can build on each other with feedback loops leading to virtuous and vicious cycles of boom and bust.

[00:10:28] Shawn O’Malley: Relatedly, the principles guiding markets and Soros’s view can differ depending on whether the market is near an equilibrium or whether it is far from equilibrium. On that point, when markets rise or fall rapidly, they are typically in disequilibrium and theories like the efficient market hypothesis become temporarily void.

[00:10:46] Shawn O’Malley: Reflexivity asserts that prices do, in fact, influence economic fundamentals, which changes expectations for the future, thus influencing prices, and the process can continue in a self-reinforcing pattern from there. Rather than trending toward equilibrium, Soros felt that markets tend toward disequilibrium until they reach a breaking point where things must reverse.

[00:11:05] Shawn O’Malley: To better understand reflexivity in practice, I’ll use an example from the 2008 financial crisis. Going back to the 1990s, as lenders began to make more money available, more people bought houses. As more people bought houses, housing prices went up. As lenders looked at their balance sheets, they saw that the collateral on their loans had increased in price significantly.

[00:11:24] Shawn O’Malley: That is to say, the homes they had lent against were now worth much more, which they interpreted to mean they could safely lend out even more money. It was a positive feedback loop. Lenders offering affordable financing stimulated demand for housing, which pushed prices up, making lenders want to issue even more loans, and so on it went.

[00:11:41] Shawn O’Malley: This was all amplified by public policies where the US government effectively guaranteed home loans. Of course, this eventually created a bubble and a falloff in housing prices triggered a sweeping reversal in sentiment that further drove down prices. As home prices came down, lenders were less confident about lending against them as collateral, which made financing more expensive and reduced demand for houses, driving prices even lower.

[00:12:04] Shawn O’Malley: So I think you can see how these forces build on each other and how these sort of feedback loops can unfold. Reflexivity explains how markets can move from a balanced equilibrium to overshooting or undershooting. Soros has often stated that his intimate understanding of reflexivity is what gave him his edge as a trader.

[00:12:22] Shawn O’Malley: He’s said to have so intimately been connected to markets that market movements and mistakes he made could actually manifest as back pain. He once remarked that, quote, I’m only rich because I know when I’m wrong. I basically have survived by recognizing my mistakes. I very often used to get backaches due to the fact that I was wrong.

[00:12:40] Shawn O’Malley: Whenever you are wrong, you have to fight or take flight. When I make the decision, the backache goes away. With some context set for Soros, let’s actually go through his book now, The Alchemy of Finance. In 2003, former chairman of the Federal Reserve, Paul Volcker, wrote a foreword for the book. I’ll just take a moment to read a passage from it.

[00:12:59] Shawn O’Malley: Quote, George Soros has made his mark as an enormously successful speculator, wise enough to largely withdraw when still way ahead of the game. The bulk of his enormous winnings is now devoted to encouraging transitional and emerging nations to become open societies, open not only in the sense of freedom of commerce, but more important, tolerant of new ideas and different modes of thinking and behavior.

[00:13:23] Shawn O’Malley: In his first chapter of the book, Soros states that he would use just one word to sum up his skills, survival. For a Jew growing up in Nazi occupied Hungary, it’s probably little surprise that survival at all costs underpins his ethos. Survival skills learned at this time set the stage for his investing approach some twenty five years later.

[00:13:43] Shawn O’Malley: As we talked about last week, getting wiped out means game over for an investor, and Soros appreciated that more than most. While leverage could amplify returns, he knew it could wipe him out if markets didn’t adhere to his expectations. Unlike those who relied on the Kelly formula to help them systematically size their bets, Soros claims to have taken a more instinctive approach, relying on his gut to help him gauge and size risks.

[00:14:06] Shawn O’Malley: Survival can sometimes mean knowing when not to do what everyone else is doing, and for Soros, that meant concluding that market prices were always wrong rather than almost always being right, as is the typical consensus on how markets function. He felt that prices at any given point reflected some biased belief about the future, And not some perfectly balanced accounting of all known information.

[00:14:28] Shawn O’Malley: Figuring out then which biases were most distorting markets represented a tremendous opportunity for him. Yet, as I’ve talked about with reflexivity, market biases can actually drive outcomes in real life. This creates the impression that markets accurately anticipate future events, But, in Soros view, it is really expectations about the future that create these same outcomes.

[00:14:49] Shawn O’Malley: For example, if everyone believes a bank is insolvent, regardless of whether the bank actually is or not, that fear will drive the masses to withdraw their money from the bank, leaving it actually insolvent. In that case, did the bank stock’s declining price accurately anticipate the bank run, or did it cause the bank run?

[00:15:07] Shawn O’Malley: Soros view, roughly speaking, is the latter. Interestingly, Soros also sees a reflexivity between regulation and the business cycle. Excesses in the business cycle tend to correspond with minimums and regulation. Those excesses then drive a sharp correction from regulators, which aligns with a reversal in the economy toward a bottom.

[00:15:26] Shawn O’Malley: If you’re watching the podcast on YouTube right now, you’ll see on the screen a chart of the business cycle to help you know what I mean here. To some extent, I think 2008 illustrates this pretty clearly. Regulators had eased up in a number of areas for years before the crash until they realized how that had enabled a bubble to form, which spurred them to make dramatic changes to the regulatory environment, especially for banks.

[00:15:47] Shawn O’Malley: Over time, as the pain of yesterday is slowly forgotten, regulations tend to loosen up, Or a blind eye is turned to new and more exciting phenomena in markets. Like the economy, the regulatory environment can be cyclical, swinging from one extreme to another. Soros makes the point that regulators are often perceived as existing on the sidelines, separate from the economic games that are played.

[00:16:10] Shawn O’Malley: They are seen as some objective referees, who interfere only when the players in the game have made a mess of things, but in reality, regulators are all too human. They are also very much players in the game too. They’re responding to what investors and businesses do, while the business world responds to what regulators do.

[00:16:27] Shawn O’Malley: As a result, since regulators are often responding to what has already happened, their regulations address the last crisis but rarely anticipate the next. He describes a wave pattern where free market economies are fluctuating between over and under regulation. Secular developments can also affect the nature of reflexive relationships and markets.

[00:16:47] Shawn O’Malley: The best illustration of this is with central banks, which I think is interesting because his point holds true to this day, almost 40 years from when the book was first published. Essentially with each crisis, central banks garner more and more power, hoping to proactively minimize the next crisis since it’s so hard to arrest a crisis once it has already begun.

[00:17:05] Shawn O’Malley: So, Soros sees this reflexivity in markets everywhere. He also sees the markets as a testing ground for hypotheses. In fact, he thinks investing isn’t so different than science. In both cases, one proposes a hypothesis and seeks to test it out, but doing so is risky because being wrong can be costly while being right is rewarding.

[00:17:25] Shawn O’Malley: To him, every market bet is like a hypothesis to be tested, helping him better understand how the world works. He writes, quote, Successful investing is a type of alchemy. Most market participants do not view markets in this light, meaning they do not know which hypotheses are being tested. It also means that most hypotheses that are submitted to market testing are quite banal.

[00:17:45] Shawn O’Malley: Usually they amount to nothing more than an assertion that a certain stock is going to outperform the market averages. He adds, quote, I had an advantage over other investors because at least I had an idea about how financial markets operate. In chapter 3, Soros zooms in more on the theoretical backdrop for the theory of reflexivity.

[00:18:04] Shawn O’Malley: He mentions how equilibrium is sort of a paradoxical thing in markets. On the one hand, we can imagine what a market equilibrium looks like in theory, where prices don’t fluctuate because the demand to buy and sell is perfectly in balance, yet the This never actually happens in practice. Prices for everything are pretty much always fluctuating, and when we make statements about bubbles and other distortions in markets, we are implicitly saying that markets have drifted from an equilibrium that we can’t observe.

[00:18:29] Shawn O’Malley: We feel that markets are not performing as they should, yet the definition of how markets should behave, such as the fair price for a two bedroom house in Austin, Texas, remains up for debate. What the equilibrium price should be is subjective. Still, that hasn’t stopped traditional economic theory from embracing the idea of the rational consumer that fits nicely into imagined equilibrium scenarios that never manifest.

[00:18:53] Shawn O’Malley: We are told that everyone acts rationally all the time, and firms produce goods up to the point where their marginal cost equals the market price, and each consumer consumes up until their marginal utility equals the market price. In Soros view, this idealized version of reality paints the marketplace as having an almost magical ability to perfectly balance supply and demand.

[00:19:12] Shawn O’Malley: The problem is that these laissez faire economic views assume that everyone in a market is acting with perfect knowledge, homogenous products, and that there’s a large enough number of participants such that no single participant can influence a market’s pricing. If that were all true, the free market would be a stabilizing force trending toward equilibrium over time.

[00:19:30] Shawn O’Malley: We know from experience though that that isn’t the case. The economy and financial markets swing like a pendulum from one extreme to another, and very little time is actually spent in a state that even closely resembles an equilibrium. The contradiction that Soros is uncovering here is that supply and demand curves are supposed to determine market prices, but what are we to make of the reality that supply and demand curves themselves are the subject of market influences by way of expectations?

[00:19:56] Shawn O’Malley: If you’re an oil producer, for example, you have to model out the expected future demand for your oil so you know how much to pump, because storing extra oil is costly. If you read a report saying the economy will likely contract next year, that expectation may lead you to pump less oil proactively. If you and all your peers pump less oil ahead of a feared recession, the corresponding oil shortage and price spike might actually cause a recession.

[00:20:20] Shawn O’Malley: The point being, we cannot take the supply of anything, in this case oil, as some independent factor that is produced without bias. Expectations in the marketplace will shape real decisions made by businesses, which shape market expectations, and so on. A big focus for Soros is to consider the shortcomings of markets in both the financial and economic sense.

[00:20:40] Shawn O’Malley: That is, not to say he dislikes capitalism or doesn’t approve of free markets. I think it’s the opposite, actually, but Soros is a pragmatist, and pragmatically speaking, it does us no good to pretend that markets are infallible and that, on their own, they always lead to the best outcomes. He cites centrally planned socialist and communist economies as having far worse distortions than free market systems, so central planning and price setting by governments is an inferior alternative.

[00:21:07] Shawn O’Malley: Still, that shouldn’t blind us from accepting how free markets can inefficiently allocate resources too. He compares free markets to Winston Churchill’s quote on democracy, where he roughly says that democracy is the worst form of government, except for all the others. In Soros view, the boom and bust of the business cycle is by no means the optimal way to organize economic activity, but it is the best of all the alternatives.

[00:21:29] Shawn O’Malley: Soros says, quote, The profit motive has become so all embracing that we find it hard to accept when someone is motivated by some considerations other than profit. Soros made his living leaning into the irrationality of markets, so he knows better than anyone what markets are good at and what they aren’t.

[00:21:45] Shawn O’Malley: For example, one point he makes is how extremes can be self-sustaining. In foreign exchange markets for currencies, a sharp depreciation in a currency can be self-validating because of its impact on that country’s price levels. That is to say, if for some inexplicable and maybe even random reason, the U.S. dollar depreciates against other major currencies, then that diminishes the U.S. dollar’s purchasing power and imports become more expensive as a result. As import prices rise, inflation indexes like CPI will start to increase. Global currency traders watching economic data for insights on what is likely to happen next to a country’s currency will see the rise in inflation and anticipate that further inflation will continue to weaken demand for the dollar and might sell dollars in exchange for other currencies, adding more to the dollar’s depreciation, which is likely to spur even more inflation until something causes the spiral to reverse.

[00:22:35] Shawn O’Malley: That is oversimplified, but directionally it’s true. A country’s currency probably won’t spiral for no good fundamental reason. But, at the same time, I think this example holds up. Some spark could cause a currency to depreciate, and then the effects of that depreciation will cause market participants to expect even more depreciation, which then actually contributes to manifesting the outcome that they initially feared happening.

[00:22:57] Shawn O’Malley: I can’t help but look at markets and see these feedback loops everywhere. U.S. stocks continue to outperform their international peers, in part because maybe there are better companies in the U.S. with stronger track records of creating wealth for shareholders, but at the same time, the U.S.’ continued relative outperformance as a desirable place to invest is as much about everyone continuing to believe that it is one.

[00:23:18] Shawn O’Malley: The fact that U.S. stocks have done better than others by itself attracts people to invest in U.S. stocks, which further boosts the prices of U.S. stocks, which then attracts more investors to invest there. The belief that America is a great place to invest sets into motion a series of events that do in fact make it the best place to invest until inevitably US stocks become so expensive with no new buyers left in the margins to purchase them that their prices must fall closer in line with global averages.

[00:23:45] Shawn O’Malley: And then conventional wisdom will come to favor something different. Maybe everyone will come to believe that Japan is where you have to be invested to earn the best returns and that will kick off a whole new cycle supporting Japanese stocks at the expense of other markets. That is, funny enough, exactly what happened in the 1980s.

[00:24:00] Shawn O’Malley: Financial markets are a melting pot for thousands, if not millions, of these different narratives, all colliding daily, with the most firmly held and widely shared narratives gaining share over others and then compounding themselves. Soros refers to this as the prevailing bias in markets. Many beliefs and markets offset each other, so what is left over is the prevailing bias.

[00:24:21] Shawn O’Malley: Everything else equal, if the prevailing bias is positive, market prices will trend upward. If the prevailing bias is negative, market prices will trend downward. One fundamental reason Soros sees market outcomes as being periodically flawed is that market participants act on imperfect information. No one has a clear picture of objective reality and every possible variable influencing market prices.

[00:24:43] Shawn O’Malley: Their information is also imperfect because their own thinking can affect what happens in markets. Many people believing one thing is likely to happen may actually cause the opposite to occur. Unlike in physics and other natural sciences, where you can generally study clear cause and effect relationships, it’s just a lot harder to do that in economics, where biases can contradict or magnify certain cause and effect relationships.

[00:25:05] Shawn O’Malley: Rather than adhering to strict laws of Newtonian physics, markets are more similar to quantum mechanics, where the act of observing a molecule changes its nature. If you’re familiar with the Schrödinger’s cat paradox, you’ll know what I’m talking about here. By observing subatomic particles, you change their state by simply looking at them.

[00:25:22] Shawn O’Malley: Soros thinks markets behave similarly, with there being an interplay between perception and reality, as there is an interplay between observation and reality in quantum physics. Because markets are made up of people capable of being biased and operating with imperfect information, changes in their beliefs about markets will alter what actually happens.

[00:25:40] Shawn O’Malley: It is less that, in Soros view, markets can anticipate recessions, and more true that expectations in markets are what manifest recessions. The flip side can also be true that market expectations can help avoid crises. He writes, quote, Financial markets can both precipitate and abort future events. In other words, financial markets constantly anticipate events both on the positive and negative side, which fail to materialize exactly because they have been anticipated.

[00:26:05] Shawn O’Malley: He adds that, quote, It’s an old joke that the stock market has predicted seven of the last two recessions. By the same token, financial crashes tend to occur only when they are unexpected. Yet, catastrophic events can still occur that are widely anticipated. Being contrarian just for the sake of being contrarian is not a recipe for success.

[00:26:23] Shawn O’Malley: He jokes that being a contrarian has become so mainstream, he is now anti contrarian. That brings us back to the question of whether markets trend towards some objective equilibrium. As a value investor, we often talk about a stock’s underlying intrinsic value as being separate from its current price.

[00:26:38] Shawn O’Malley: So in a sense, intrinsic value is like an equilibrium for a stock’s valuation. As in, a stock’s price should trend towards its intrinsic value, which is derived from the business’s ability to generate profits. However, that thinking is incomplete because it assumes that the stock’s price, and the stock market generally, will not alter the fundamentals of the business.

[00:26:58] Shawn O’Malley: But they are not completely independent things that can be treated separately. A higher stock price can have a range of benefits, from enabling a company to afford acquisitions of other businesses to employee morale and being able to attract better talent with stock based compensation. The stock price has a reflexive link to intrinsic value because the market price can influence the fundamentals of the business.

[00:27:17] Shawn O’Malley: Conversely, a declining price reduces a company’s ability to raise financing through fresh shares of stock and can weigh on employee morale and even customer’s perceptions of the company. Those are sort of direct examples of how a stock’s price can affect its fortunes, but there are also indirect effects too.

[00:27:33] Shawn O’Malley: The performance of the stock market, more generally, may influence people’s propensity to save, taxation rates, and even regulation. If the market is booming, more people will be enticed to save and invest, which can actually change their consumption patterns and businesses earnings. And with taxation, if governmental officials think that there is a surge in wealth creation that they’re not getting a fair cut off, Then they might be inclined to increase taxation rates in response, impacting both consumers and businesses.

[00:28:00] Shawn O’Malley: I don’t see this at all as a rejection of Ben Graham and Warren Buffett’s insights that intrinsic value can be seen as something separate from market prices, but this is an interesting wrinkle to that conversation. On the one hand, yes, I do believe market fluctuations do not perfectly line up with changes in intrinsic value.

[00:28:16] Shawn O’Malley: It’s crazy to think that a 5 percent swing in Apple stock one week, followed by a swing back the next week actually reflects real time changes in the company’s fundamentals. Yet, on the other hand, as I’ve mentioned, we can’t pretend that market prices don’t affect underlying business value at all either.

[00:28:30] Shawn O’Malley: A chronically depressed stock price can be a real competitive disadvantage that compounds upon itself. Soros makes the argument that stock prices are always distorted, meaning they are always biased in one way or another, and rather than being some passive reflection of how a company is performing, they’re an active ingredient that determines outcomes for companies.

[00:28:48] Shawn O’Malley: So, we’ve talked here about how there are reflexive relationships in markets and how expectations and biases can alter outcomes in both markets and the real economy. You might be wondering then, what causes self-sustaining trends to reverse themselves? As momentum in one direction compounds, Soros suggests that it eventually hits a breaking point where the expectations can no longer possibly match up with reality.

[00:29:10] Shawn O’Malley: That is to say, for a time, negative expectations among participants in the economy and markets can manifest and accelerate a recession. But at some point, sentiment becomes so negative that it exceeds the real downtrend in the economy. Things cannot possibly be as bad as people expect them to be, and from that point on, sentiment becomes incrementally more positive, which supports a recovery in the economy.

[00:29:32] Shawn O’Malley: A self-reinforcing cycle begins, then in the opposite direction. To make the point on reflexivity, Searle shares how his understanding of it helped him profit from a boom and bust cycle in conglomerates in the 1960s and 1970s. Conglomerates were a novel form of corporate structure and despite that being a taboo word today, at that time, conglomerates were exciting to many investors.

[00:29:54] Shawn O’Malley: At first, most conglomerates were judged on their individual merits, but eventually they were lumped together and judged collectively. Because the companies with some of the most reliable and fastest growing earnings in markets were conglomerates, these conglomerates traded at higher valuation in multiples.

[00:30:09] Shawn O’Malley: These richer valuations stemming from higher stock prices gave them more currency to make acquisitions with. He says that this conglomerate boom was underpinned by a mistaken view from investors who cared primarily about just growth in earnings per share, not how that growth was manufactured. Some conglomerates use acquisitions as a tool simply to grow earnings, which is rewarded by investors who bid up their stock price, enabling them to make more acquisitions by offering new shares of their highly priced stock to other companies.

[00:30:37] Shawn O’Malley: Eventually, he says, quote, a company could receive a high multiple just for promising to put it to good use in making acquisitions. This gave birth to a new type of investor, a group that specialized only in investing in conglomerates and maintain close relationships with the management teams at these companies.

[00:30:52] Shawn O’Malley: Soros recognized that as valuations expanded, reality could eventually no longer sustain expectations. More and more people came to recognize that valuation multiples were being pushed artificially higher by investors affinity for acquisitions, while many of these acquisitions failed to create value for shareholders and were made to look better on paper due to manipulative accounting practices.

[00:31:13] Shawn O’Malley: Of course, there was a logical extreme for this mania where things would have to end at some point, For the momentum in acquisitions to continue as conglomerates grew, they’d have to make bigger and bigger acquisitions to move the needle until there were no companies large enough worth acquiring. He rode the wave up, investing in conglomerates as valuation multiples increased and supported more acquisitions.

[00:31:34] Shawn O’Malley: He then profited on the way down as well from the reversing trend in reflexivity. As stock declines diminished valuation multiples, this limited conglomerate’s ability to make acquisitions, which further weighed on their stock prices. Making things worse, problems that had been swept under the rug during the boom reared their head on the way down, consuming investors’ attention and biasing them more greatly away from conglomerates.

[00:31:56] Shawn O’Malley: A prevailing bias toward conglomerates created a cottage industry around acquisitions and changed the structure of financial markets, which gave way to a countervailing bias against them. According to Soros, the mistake many investors make is getting too narrowly focused on a given reflexive trend in markets.

[00:32:12] Shawn O’Malley: An expert on internet and biotech stocks in the 1990s, marijuana stocks in the late 2010s, or blockchain companies and AI stocks today might embrace their fame and attention while there is market bias in favor of their niche, but they are the most blind to when the tides turn and investors love for their sector leaves them ostracized when a new reflexive trend takes over.

[00:32:32] Shawn O’Malley: I think Cathie Woods has been a pretty prominent example of this recently. The spotlight really was Shane Braley on her in 2021 and she seemingly couldn’t do anything wrong. Everyone loved the speculative companies she bet on to change the world with their innovative technology. While she continued to invest in many of the same companies, investors interest has just turned elsewhere, which you can see by the falloff in returns for the type of companies that she’s invested in.

[00:32:57] Shawn O’Malley: As Soros puts it, when long term trends come to an end, short term volatility picks up. To assess the merits of reflexivity, Soros suggests we must distinguish between his ability to earn profits with his strategies based around reflexivity and the ability to use reflexivity to predict future events. He says that his financial success is in sharp contrast to his ability to predict the future.

[00:33:19] Shawn O’Malley: Events in the financial world determine his success as an investor, but events in the real world are what determine the merits of his theory on reflexivity more broadly. Soros adds that even when predicting events in financial markets, his record is flawed. Reflexivity has largely helped him understand the significance of events as they’re happening, rather than enabling him to confidently anticipate what will happen next down the road.

[00:33:42] Shawn O’Malley: While you might think that Soros must make firm forecasts of the future, he writes that his process is more one of constant revision. Any forecast he makes is done so tentatively, with an eye to how changes in markets have impacted those forecasts and whether revisions should be made. It’s fair to wonder how, as Soros puts it when referring to his career, Financial success can be reconciled with predictive failure.

[00:34:05] Shawn O’Malley: For Soros success, he credits his incredibly sharp focus as well as his willingness to write out his decision making process. He forced himself to reflect on how every decision was made and the outcome and consider what could have been improved or done differently. Still, some periods were easier for him than others.

[00:34:21] Shawn O’Malley: In the early 1980s, Soros tried to continue designing hypotheses to test in markets, but he found that a mania in bond prices was accelerating the pace of change. By the time he’d identified an actionable hypothesis to trade on, conditions would have already changed and the opportunity would be gone.

[00:34:36] Shawn O’Malley: After realizing he lagged the market’s every move, he stepped aside, at least from bond trading, to let others partake in what he saw as a casino. Basically, he recognized that the odds weren’t in his favor and he had the discipline to step away, which is not something everyone would be able to do. Some might have persisted endlessly, stubbornly hoping to finally crack the code.

[00:34:55] Shawn O’Malley: Soros was too pragmatic though to let his ego get a hold of him in that way. Still, Soros admits that his approach with reflexivity has worked better in financial markets than in the real world. That’s because financial markets themselves fail to perfectly predict what will happen in the real world.

[00:35:10] Shawn O’Malley: Prevailing expectations can periodically be at odds with the actual course of events, which is somewhat contradictory since we’ve discussed in detail how expectations can shape real events too. The complicating reality is that both things can be true. Market expectations can both affect the real world and bend to its prevailing biases or fail to do so.

[00:35:28] Shawn O’Malley: He suggests that his framework for testing hypotheses is actually similar to what markets themselves do. He believes that, in a way, markets, through their expectations, submit their own hypotheses to test. Some become reality, and others don’t. Hypotheses that survive these tests are reinforced, while others are disregarded.

[00:35:46] Shawn O’Malley: As Soros writes, quote, The main difference between me and the markets is that markets seem to engage in a process of trial and error without the participants fully understanding what is going on, while I do it consciously. Presumably, that is why I can do better than the market. He adds, quote, Treating the market as a mechanism for testing hypotheses seems to be an effective hypothesis.

[00:36:05] Shawn O’Malley: It produces results that are better than a random walk. Soros thinking is unique, to say the least. When determining what made someone successful, it’s hard to pinpoint it down to any single thing, and I’m even at times skeptical of someone’s rationalization of their own success. I do find Reflexivity and Soros view on using markets as a place to test hypotheses very interesting.

[00:36:26] Shawn O’Malley: But I’m not sure if that really explains his accomplishments. He thinks that they do, but you could imagine that he is the most biased person to ask about his own success. I think it’s more likely that the type of person who can bring such a creative and philosophical framework for understanding markets is likely to be successful because they’re just wired differently from everyone else.

[00:36:45] Shawn O’Malley: My takeaway is not to become some expert on reflexivity so I can try and be the next George Soros, but I do think reflexivity is a very helpful framework to reference when trying to understand financial markets. The Alchemy of Finance is a challenging book to read, so it’s not one I would go out of my way to recommend to people.

[00:37:00] Shawn O’Malley: That is not to say it’s not a good book, It just requires a lot of context on Soros career and the time the book was written, as well as an understanding of traditional micro and macroeconomic theory, since he spends a lot of time railing against their flaws. Just from his writing style, you can tell Soros is an intuitively abstract thinker and quite intellectual, which can make his writing less approachable.

[00:37:20] Shawn O’Malley: I did my best to simplify and give some examples of how Soros thinks about markets and how to best understand his theories, but there is definitely another level of understanding I think can be garnered from reading the book. Although it can take some time to work through, the book is really not very long at all, and there is an abridged version of it on Audible that has a runtime of less than 4 hours.

[00:37:38] Shawn O’Malley: I don’t have any illusions of trying to be a trader like Soros. Shorting currencies and betting on reflexive trends in stocks or the broader economy isn’t exactly my style, but I enjoyed the chance to learn more about Soros as an investor, and I think his ideas on reflexivity broadly are relevant to everyone.

[00:37:54] Shawn O’Malley: Especially in considering how stock prices can reflexively influence underlying companies. It’s really common to try and separate business fundamentals from stock prices, and to treat the operating business as something that exists in a vacuum. But that’s just not reality. You don’t want to obsessively watch stock prices, but it’s useful to consider whether a stock’s price has over time been supportive of or detrimental to the underlying business.

[00:38:18] Shawn O’Malley: Tesla is a really good illustration of this. Elon Musk’s fame and the stock’s incredible returns have undoubtedly helped the underlying car business. Tesla has a diehard base of folks who are both investors in the company and passionate drivers of their cars. Tesla has also been able to raise a ton of money at premium valuations, thanks to its stock price.

[00:38:36] Shawn O’Malley: And I’m sure that reputation has also helped Tesla attract some of the world’s best engineers and software developers. So, reflexivity is real. Tesla is an extreme case, but in valuing the business, you have to account for the interplay between the underlying business and the stock price itself. The same is true, to a lesser extent, for any listed company.

[00:38:55] Shawn O’Malley: I also found it really interesting to hear Soros talk about how he could anticipate crises and other sharp changes to the status quo in markets from pains in his back. I’m not sure how a doctor would respond to that, but it makes sense to me, at least, that one can be so consumed by something that their subconscious mind finds strange ways to communicate information to the conscious mind.

[00:39:14] Shawn O’Malley: Perhaps his subconscious was picking up on trends that he couldn’t consciously identify, and his heart and soul were so in sync with market patterns that they gave him advanced insights. Even if the back pains were completely random, I don’t think that’s the point. Instead, the fact that that is even believable is telling of just how deeply involved he was in the hypotheses that he tested in markets.

[00:39:34] Shawn O’Malley: He was constantly philosophizing about markets while managing his portfolio, and he’s the first to admit that doing so came at the expense of relationships in his life. From my studies, that’s true of so many great investors. They’re so consumed by their work that they seem to miss out on some of the most important things.

[00:39:51] Shawn O’Malley: Not that I expect many of you listening to this are hoping to be the next George Soros, but if you are, you should know what you’re getting into. You ought to be prepared to have your conscious and subconscious mind so consumed by pondering opportunities and markets that your body physically responds to financial inflection points.

[00:40:07] Shawn O’Malley: That really just signals to me how maniacally focused he was on winning as an investor, and it’s a rare type of person who can bring that degree of concentration, competitiveness, and intellectual power to investing. At the end of the book, Soros goes through some recommended practical reforms for the financial system, and he qualifies that by saying that every new system will only be temporary, since no system is permanent, and whatever successes it has will set the stage for its ultimate failure.

[00:40:33] Shawn O’Malley: It is, again, a very philosophical way to say things. His primary idea seems to be the creation of a universal central bank as a way to address the shortcomings of free markets and their tendency toward boom and busts. I appreciate though that he recognizes that every idea is flawed, but that shouldn’t be an excuse not to try and improve upon the world around us.

[00:40:52] Shawn O’Malley: In the epilogue, he ventures into some even more abstract areas, discussing how reflexivity plays into other things, like the relationships between our self-perception and how we live our lives. He says quote, What we think has a much greater bearing on what we are than on the world around us. What we are cannot possibly correspond to what we think we are, but there is a two way interplay between the two concepts.

[00:41:13] Shawn O’Malley: As we make our way in the world, our sense of self evolves. The relationship between what we think we are and what we are in reality is the key to happiness. In other words, it provides the subjective meaning of life. He admits that in his own life, his own glorified self-perceptions plagued him for a long time.

[00:41:30] Shawn O’Malley: Since he was young, he says that he’s seen himself as something of a god, and even the name Reflexivity is meant to mirror Einstein’s theory of relativity. That vanity and self-perception is something that troubled him for many years, until he came to terms with that as an adult and is now able to speak more openly about how self-perception has affected him.

[00:41:49] Shawn O’Malley: Reality often falls far short of his expectations, but he suggests that it no longer brings him a sense of guilt or failure. Financial markets helped him come to terms with his own mortality and fallibility. I think it’s only fitting that today’s episode on George Soros is being wrapped up on such a profound note.

[00:42:05] Shawn O’Malley: Soros is an immensely interesting person to study, and I know his views on markets have resonated deeply enough that I will continue to reference back to his theories for many years to come probably. I hope you enjoyed today’s episode and thank you again for joining me in focusing on George Soros as an investor and not being distracted by some of the more political reasons people dislike him.

[00:42:24] Shawn O’Malley: I’ll leave you with one last quote from Soros to end today’s episode. He says, quote, Once we realize that imperfect understanding is the human condition, there is no shame in being wrong, only in failing to correct our mistakes. That’s all for today, folks. I’ll see you next time.

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