The financial crisis of 2008 was of such an unprecedented severity that it left many investors looking for atypical answers. Did we not have all the financial theories in place so that we were supposed to have the ability to foresee and forestall disasters of such magnitude? What did we miss?

Some people found answers in one of these two books: “The Black Swan – The Impact of the Highly Improbable (2007)” by Nassim Nicholas Taleb, and “The Crash of 2008 and What it Means – the New Paradigm for Financial Markets (2008)” by George Soros.

Mediocristan. He contends that financial markets are not like Mediocristans, and normal distribution does not apply to stock market returns.  Instead, financial markets belong to what he calls Extremistan, where extreme results happen quite often. Indeed, many financial institutions which have lost big money had sophisticated risk models built, yet they were caught unprepared. Why does the academic circle choose to believe that financial markets are Mediocristans, when reality clearly shows that they are not? Taleb offers several causes for this error, such as shortcomings in the logical analysis of many people, or most people’s desire to avoid uncertainty, a situation which can create acute anxiety in some people.

His whole book, in short, is a collection of arguments for one point: extreme conditions happen in the financial market more often than we think. His solution?  Be prepared for Black Swans so that we can take advantage of them when they come, even though they do not come too frequently. Be willing to live a quiet life most of the time, while waiting for a Black Swan.  With the 2008 Financial Crisis fresh on our mind, his arguments are convincing. However, as a market practitioner, I find Soros’ book more useful. To a general reader, Soros book also contains less anger towards the authors’ respective detractors, and thus has room for more useful ideas.

The main theme of Soros’ book is about reflexivity, a concept that is applicable to systems where human decision making has a crucial role. While Taleb targets his complaint about conventional financial theories at the wide spread use of normal distribution in anticipating changes in market returns, Soros’ focuses his criticism on the theory of equilibrium – that market prices tend towards equilibrium, which is essentially determined by the demand and supply of a financial product. Soros’ reflexivity theory contends that in financial markets, prices are affected by the participants’ view of other participants’ thinking. In other words, there is a two-way connection between the thinking of the various participants. In addition to this, the concept of reflexivity states that there is an element of indeterminacy (unpredictable on the basis of scientific laws) in a reflexive system.  This indeterminacy is introduced into the system because people usually have a distorted view of reality. Example : people change their view about the state of affairs even when no real material change to it has happened, as a result of what they see in other people’s action.

Soros concedes that reflexivity in the financial markets occurs only intermittently. Soros asks readers to distinguish between everyday events that are statistically predictable, and reflexive processes that are not.

When one analyses the financial market, or any market, on a first principle basis, reflexivity seems to be a matter of course.  For any stock or product, a market price is established when the buyer thinks he can sell it at a higher price later, while the seller thinks otherwise. In other words, the decision of each one is based on what they think others will do later.  The equilibrium theory “holds that under the specified conditions the unrestrained pursuit of self-interest leads to the optimum allocation of resources. The equilibrium point is reached when each firm produces at a level where its marginal cost equals the market price, and each consumer buys an amount whose marginal utility equals the market price.” That is a manufacturer/consumer angle of equilibrium theory.  I would criticize the equilibrium theory as it applies to the financial market in a different way: under equilibrium theory, the equilibrium price is reached when demand and supply meet, and the only determinant of demand and supply is the price. However, people buy stocks for one reason only, to sell it at a higher price later.  Marginal cost is of relevance only as far as the minimum selling price is concerned. But people want to maximize profit, and to do so they form opinions about how much higher other people would be willing to pay for his stocks later. It is not the utility value to him that matters, but the likely actions of others.  The theory of reflexivity suggests that the price that a person is willing to sell a stock is dependent upon that person’s view of what other participants would do (person A may or may not sell his shares at a particular price, depending on what he thinks others will do in future).  In my view, since (i) there are so many factors that will affect other participants’ decision to buy or not, (ii) such factors can change over time, and (iii) there are many ways that one can project how these factors will affect other participants’ behavior (most of them are wrong, according to Soros), equilibrium is not possible.

When a prevailing bias is allowed to occur in the financial market, the reflexivity mechanism will likely turn the bias into a financial crisis. The examples that Soros gave in support of this Boom-bust model are valuable lessons for market participants. The conglomerate boom of the 1960s : conglomerates increased earnings per share by making acquisitions of companies in unrelated businesses, and investors lapped it up, ignoring how the earnings were achieved. CEOs used the inflated price of their company stocks to make more acquisition. Before reaching the point where such strategy could not be sustained by actual company performance, the price of the company’s stock kept climbing, thus further fueling the growth-by-acquisition strategy.  The result was of course a bust.

Another example of the boom-bust model given by Soros was the Real Estate Investment Trust (REIT), an investment vehicle that allows individuals to enjoy the economic benefits of leasing properties.  A law that provides the framework for creating REITs in the Philippines is in the final stage of being approved. When REITs started to mushroom in the USA in 1969, Soros said he “immediately recognized their boom-bust potential”. He postulated that “instead of predicting future earnings and valuations separately, we should try to predict the future course of the entire initially self-reinforcing but eventually self-defeating process”.  This is very insightful. Instead of looking at the performance of companies, he looked at the investment ecological system. He projected how skillful players will use other investors’ mindsets (especially the mistaken ones) to their own advantage, and that how these players could in the end be self-destructive: CEOs of REITs used overvalued share prices to make eventually reckless investments, similar to investment banks in the current financial crisis using risk-shifting financial products to increase their income, but ultimately reality caught up as easy money dried up, and then they realized belatedly they had taken on more risk than they could handle.

Thus, while Taleb urges us to expect the unexpected, Soros tells us that many of the unexpected actually are outcome of reflexivity. If we watch out for boom-bust models which occur as extreme cases of reflexivity, we can spot some good investment opportunities.

As a side track, when REITs finally arrive in the Philippines, I hope retail investors will not fall into the reflexivity trap, but instead look at both the rental income prospect as well as the stock price at entry before investing.