The Alchemy of Finance (George Soros) 2 comments

He is one of the legends in the investment industry and everybody within the financial circles as well as many members of the public know of him, the latter perhaps notoriously due to his alleged part in the 1997-98 Asian currency crisis. On the basis of his >30% compounded annual return for nearly 30 years running big money, any book by George Soros (see my article on the man) has to be worth paying attention to.

The problem is that it is not easy to understand Soros' book. Part of the problem is because Soros ran his Quantum hedge fund along global macro lines, making bets in currencies (his specialty), bonds, commodities, stock indices. Hence his was a top-down approach focusing on understanding structural macroeconomic changes and their impact on various asset classes. Reading the book entails a strong understanding of macroeconomics in the first place.

The contents of this book is particularly relevant now because we have just experienced a major dislocation on the global markets which illustrates clearly the merits of at least a rudimentary understanding of macroeconomics; the book describes in particular, how a bubble can form in various asset classes and then tailspin in a destabilising rather than self-stabilising manner, what Soros grandly calls an "imperial circle".

The key theme running through the book is what Soros describes as his theory of "reflexivity". In essence, reflexivity is about the feedback effect, or a two-way coupling between cause and effect, such that the latter actually flows back to influence the former. With specific reference to investment, it means that prices do in fact influence the fundamentals (instead of the mere textbook theory of fundamentals driving prices) and that these newly-influenced set of fundamentals then proceed to change expectations, thus influencing prices. This self-reinforcing pattern in fact is what causes the destabilising nature of markets in severe dislocations.

Although this is really nothing new, it is worth reading about Soros' thinking process in action in the second part of the book, where he describes his trading experiences in a window period from 1985-86 (which unfortunately doesn't capture his most famous episodes eg. his breaking of the Bank of England). He outlines his thinking and trading patterns in what he calls his "real-time experiment" (he has a penchant for grand phrases), which turns out to be rather complex and yet natural to him; others who read about his philosophies and methods, I think, cannot practise what he preaches, unless they can internalise it, and that takes years of experience.

The book is rather hard reading, and I consider myself to have quite good grounding in macroeconomics, so it might be worse for others. The main idea to take away from the book is a corollary of the "reflexivity theory": the stock price can and does influence the fundamentals of the stock/company. The most direct manner is that a high stock price/high PE facilitates low-cost fund-raising on the capital markets, and hence the company can expand organically or make new acquisitions more easily. At the same time, should the process reverse, the negative impact on fundamentals could run like a nightmarish set of dominos.