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The Alchemy of Finance: Reading the Mind of the Market – George Soros

7th January 2021
The Alchemy of Finance book cover

Introduction

The Alchemy of Finance is a book about the theory of reflexivity. This is the author’s own theory about the behaviour of the financial markets. He is using his experiences to develop an approach to the study of historical processes. Since the author is a great trader, I would like to know what he is sharing in this book. Furthermore, this book is recommended in several investment blogs.



Author

George Soros is an American billionaire investor and philanthropist. He was born in Hungary but fled the country during the Second World War. His first hedge fund was Double Eagle and the next one was Soros Fund Management which was renamed to Quantum Fund. The author is best known as The Man who Broke the Bank of England.

He used his fortune to create Open Society Foundations which support freedom of expression, accountable government, and societies that promote justice and equality. The author has donated more than $32 billion of his personal fortune to fund the Open Society Foundations’ work around the world. He is also the founder and primary funder of the Central European University in Budapest, a leading regional center for the study of the social sciences.



Contents

The Alchemy of Finance has a foreword, a preface, 20 chapters, and an epilogue. The foreword is written by Paul Tudor Jones II, a great trader himself. The chapters are grouped into 5 parts.

Part I is Theory. It contains 4 chapters. These are The Theory of Reflexivity, Reflexivity in the Stock Market, Reflexivity in the Currency Market, and The Credit and Regulatory Cycle.

Part II is Historical Perspective and has 5 chapters. These chapters are The International Debt Problem, The Collective System of Lending, Reagan’s Imperial Circle, Evolution of the Banking System, and The “Oligopolarization” of America.

Part III is The Real-Time Experiment. The 5 chapters here are The Starting Point: August 1985, Phase 1: August 1985 – December 1985, Control Period: January 1986 – July 1986, Phase 2: July 1986 – November 1986, and The Conclusion: November 1986.

Part IV is Evolution and has just 2 chapters. They are The Scope for Financial Alchemy: An Evaluation of the Experiment, and The Quandary of the Social Sciences.

Part V is Prescription. This part consists of 4 chapters. These are Free Markets Versus Regulation, Toward an International Central Bank, The Paradox of Systemic Reform, and The Crash of ’87.

There is an appendix titled Prospect for European Disintegration at the end of the book, which is a speech given by the author in Germany.



Review

The Alchemy of Finance introduces the theory of reflexivity developed by the author to describe the behaviour the financial markets. Reflexivity comes from the word “reflexive” which means the components influence each other mutually. In the financial markets, the examples include monetary and real phenomena.

Reflexivity involves cognitive function (in which the participants’ perceptions depend on the situation) and participating function (in which the situation is influenced by the participants’ perceptions). Thus, this interaction does not produce an equilibrium but a never-ending process of change.

The author argues that the participants’ understanding is imperfect because their thinking affects the situation to which it relates. In simpler term, reality is dependent on participants’ perception.

He is of the view that market valuations are always distorted and the distortions can affect the underlying values. Thus, markets are always biased in one direction or another; markets can influence the events that they anticipate.

The trend in stock prices is a composite of underlying trend and prevailing bias. Fundamentals influence participants’ perceptions through cognitive function; the resulting change in perceptions affects the situation through the participating function.

It means that stock markets valuations have a direct way of influencing underlying values through the issue and repurchase of shares and options and through corporate transactions of all kinds. There are also more subtle ways in which stock prices may influence the standing of a company: credit rating, consumer acceptance, management credibility, and others.

The influence of the above factors on stock prices is fully recognized; but the influence of stock prices on these factors is ignored by the fundamentalist approach. So, fundamental analysis can establish how underlying values are reflected in stock prices, while reflexivity theory shows how stock prices can influence underlying values. In short, one gives a static picture, the other a dynamic one.

In this book, the author describes a typical boom/bust sequence.

Unrecognized trend → Beginning of a self-reinforcing process → Successful test → Growing conviction, resulting in a widening between reality and expectations → Flaw in perceptions → Climax → A self-reinforcing process in the opposite direction

This typical boom/bust sequence is initially self-reinforcing and eventually, self-defeating. The participants cannot prevent a boom from developing even if they recognize that it is bound to lead to a bust. But it can be aborted or diverted at any point. Nonetheless, he admits that this typical boom/bust sequence is not directly applicable to all reflexive processes.

To the author, financial history is best interpreted as a reflexive process in which there are two sets of participants: competitors and regulators. He opines that financial markets need to be regulated, though he admits that both regulated and free markets are imperfect. Nonetheless, the failure of one extreme is no justification for turning to the other. Instead, they should be treated as limits, within which right balance needs to be struck.

The author challenges classical economic theories in this book as he believes they do not work in real life. Other than the theory of reflexivity, the author also introduces the brink model in later chapter. It means that when disaster threatens, the authorities pull together; when the danger recedes, they pull apart. This causes the fundamental problems in the financial markets to be never resolved. He has interesting proposals for the financial markets: an international currency and an international central bank. However, he also foresees that these measures would not be implemented easily.

In a nutshell, reflexivity is not in operation in all markets at all times; but if and when it occurs, there is no limit to how far away both perceptions and events can move from anything that could be considered equilibrium. Thus, reflexive processes are bound to lead to excesses.

The author has mentioned that this is not a guide to getting rich in the stock market. It is a collection of his thoughts on the financial markets. From this book, we can see that the author has a clear view and keen observation. Besides that, he is not afraid to admit mistakes and uncertainty.

Although this is not technically an investment book, it does teach me a few things about investment, especially the theory of reflexivity. One particular lesson that rings true to me is this: financial success depends on the ability to anticipate prevailing expectations and not real world developments. I think this is a very good book to get into the mind of one of the most successful traders.



Quotes

  1. Buy and sell decisions are based on expectations about future prices, and future prices, in turn, are contingent on present buy and sell decisions.
  2. Regulations are generally designed to prevent the last mishap, not the next one.
  3. Values that motivate people cannot be readily translated into objective terms; and exactly because individual values are so confusing, we have elevated profit and material wealth – which can be readily measured in terms of money – into some kind of supreme value.
  4. The fact that no system is perfect is not a valid argument against trying to perfect the system.
  5. 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.


Rating

3 out of 3 stars



Interested in The Alchemy of Finance?

You may get the book from through the links below*.

Get the print book from Kinokuniya Malaysia here

Get the audio book from Rakuten kobo here

*Disclosure: The above links are affiliate links. Thus, I may earn a small commission when you purchase the book through these links.

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