Theory of Reflexivity

George Soros, who is popularly known as the man who broke the Bank of England and as the man who was responsible for a large number of stock market and currency market crashes (including the asian currency crisis) had operated by focusing heavily on the theory of reflexivity.
The theory of reflexivity is very interesting and helps investors and speculators in identifying phases of market disequilibrium and helps him/her profit from such phases of market disequilibrium.
The theory of reflexivity acts in sharp contrast to the Efficient Market Theory which states that the market is perfect and the stock prices will discount/factor-in all known and unknown (insider) information.
The theory of reflexivity states that any significant events / developments can disrupt the market equilibrium and the market becomes a victim of irrational exuburence.
When there is a bad news people start selling and hence prices tumble. Looking at the stock prices tumbling, people start selling more because of fear, stock prices fall further and the viscious circle continues. Similarly, when there is a good news stock prices increase. People become excited, buy more stock and the stock prices rise even further and thus the chain continues.
This is where a rational economic man / value investor would identify the opportunity. Though stock prices might temporarily behave irrationaly, research has proved that over the long term, stock prices reflect a company’s performance.
Hence it is important that an investor enters the market and takes positions when the market is in disequilibrium and waits patiently for the markets to return to their equilibrium state and then reverse the positions taken.

Possible causes of inequilibrium are favourable or unfavourable political development (SUN TV/RAJ TV scrips after the DMK-Marans family feud), corporate announcements (bonus, stock split, rights issue, new orders and so on). In such cases stock prices may move irrationally because of reflexivity.
Posted in Fundamental Analysis,