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The forces driving Soros
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lg_6273
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19-Jun-2007 19:55
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In the second of a series on the world's greatest investors, CHARMIAN KOK describes George Soros's controversial style AS the 80th richest person in the world (according to Forbes), multi-billionaire George Soros is a household name when it comes to investing and finance. Dubbed 'the man who broke the Bank of England', he remains one of the most talked-about and controversial figures of our time. Fiercely-opinionated and often the centre of debate, Soros has made headlines for ethically-questionable deals, his philanthropic activities and voicing his political views. In 1992, Soros gained instant fame when he sold short more than 10 billion, profiting from the devaluation of the sterling pound and earning him US$1.1 billion. Similarly, he made a name for himself during the late 1990s Asian financial crisis, when then Malaysian prime minister Mahathir Mohamad accused him of bringing down the Malaysian ringgit. Soros faced the Nazi occupation of Hungary when he was just 13 years old. Subsequently, his family fled from Hungary to escape the persecution of the Jews. Moving to London in 1947 to study economics at the London School of Economics, he met his mentor and philosopher Karl Popper, who would eventually influence many of his beliefs, ideas and even investing strategies. Soros founded Quantum Fund in 1970 together with Jim Rogers, and was largely responsible for its success. Although it faced huge losses in technology stocks in 2000, the fund also saw many million-dollar deals and returned more than 4,000 per cent over ten years. Typical of Soros's investment style is his ability to translate economic trends into highly leveraged killer plays in bonds and currencies. As an investor, Soros is a short-term speculator, making huge bets on the directions of financial markets. Above all, he believes that financial markets are chaotic and unpredictable, and largely dominated by a herd mentality. According to him, prices of securities and currencies are dependent on people who often bought based on emotion, rather than logical decisions. Throughout his fifty-year career, Soros has published many essays and reports popularising his ideas on market fundamentalism and reflexivity. We will now take a look at how some of Soros's philosophies and beliefs have translated to his investing strategies. FALSIFIABILITY To fully comprehend the ideas that have shaped Soros's views about the economy and his investments, we must first go back to the basics - to the man who helped mould his intellectual beliefs, Karl Popper. Soros himself attributes his investment strategies to Popper's understanding of the advancement of knowledge through falsification. An important concept in the philosophy of science, falsifiability implies that a proposition or theory cannot be scientific unless it admits the possibility of being shown false. This is not to say the proposition or theory must be false; merely the possibility of being false is enough. Falsificationists believe that any theory which is not falsifiable is unscientific, and many viewpoints in economics are often accused by sociologists and social scientists for lacking falsifiability. The most common argument, for example, is made against the rational expectations theories. Although seemingly paradoxical, Soros deeply believed in falsifiability and was to later base his subsequent theories and investment strategies on this basic principle. MARKET FUNDAMENTALISM Another theory that Soros held is 'market fundamentalism' - a term coined by him to criticise the philosophy that the free market is always beneficial to society and that the common good is best served by market forces. Soros explains: 'I put forward a pretty general theory that financial markets are intrinsically unstable. There is the prevailing theory which holds that financial markets should be regarded as if they were in continuous equilibrium. I think that is actually a false imagine because, in effect, they are in continuous disequilibrium. Therefore, they are given to going to excesses in one direction or another. You can have a boom and a bust.' Soros further claims that markets are genuinely unpredictable, and authorities and governments are needed to regulate markets to ensure public interest is upheld. 'If you leave markets to themselves, they actually go to extremes and lead to financial collapse. So you need the presence of the authorities to keep the markets on a reasonably even keel,' he says. This seems to go against the widely held notion that markets tend towards equilibrium. However, Soros further extends this theory to show how it does not work in reality. REFLEXIVITY In an interview, Soros once said of Warren Buffett's investing strategy: 'I personally, for instance, am not dependent on the kind of, or guided by the kind of, fundamentals that he's guided on, because I believe that markets are reflexive, and market sentiment is one of the fundamentals that you have to take into account.' There is little doubt that both gurus' investing styles are as different as night and day. While Buffett relies on the fundamentals of a business, Soros studies and uses market trends to his advantage and, for him, reflexivity is the key concept to understanding market trends. Reflexivity suggests that the biases of individuals enter market transactions, potentially changing the fundamentals of the economy. Soros argued that such transitions in the fundamentals of the economy are often marked by disequilibrium instead of equilibrium. Therefore, the conventional theory of efficient market hypothesis does not apply in such situations. Associate editor of UK Times Anatole Kaletsky explained: 'Reflexivity magnifies errors in financial markets by transferring the erroneous perceptions of investors into the real economy and then reflecting them back into market prices in an exaggerated form.' Elaborating more about this idea of reflexivity in his book Alchemy of Finance, Soros believes that our distorted perceptions are a factor in shaping events and that 'what beliefs do is alter facts'. An example of this is when stock prices rise; making it seem like the economy is improving. This further prompts investors to become even more optimistic, leading to more buying and the market rising further. This self-reinforcing process was called 'reflexivity'. Reflexivity can be used to explain many boom-and-bust cycles in our economy. Soros wrote: 'A boom/bust process occurs only when market prices influence the so-called fundamentals that are supposed to be reflected in market prices.' His strategy therefore lies in watching for situations where the market's perceptions diverge widely from the underlying reality. Mark Tier, author of The Winning Investment Habits of Warren Buffett and George Soros, describes Soros's investing strategy: 'On those occasions when Soros can see a reflexive process taking hold of the market, he can be confident that the developing trend will continue for longer, and prices will move far higher (or lower) than most people using a standard analytical framework expect.' For many, Soros's philosophy, beliefs and investment strategies may defy the conventional wisdom and even raise a few eyebrows. Certainly, many economists who believe that financial markets are often near-perfect equilibriums dismiss Soros's ideas. However, they are not the ones making million-dollar deals. |
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