“The Alchemy of Finance,” by George Soros, Hoboken, N.J.; John Wiley & Sons Inc., 2003; 391 pages, US$19.95.
NEW YORK (HedgeWorld.com)– In “The Alchemy of Finance,” originally published in 1987, George Soros expounded a framework for understanding financial markets and, as a case study, described his investment decisions for Quantum hedge fund. Now there is an updated edition, with a substantial new introduction.
“Understanding reality, and financial markets in particular, is a never-ending process,” Mr. Soros writes, explaining that he sees weaknesses in his previous exposition and will try to provide a succinct statement of his current thinking on the subject.
It is not surprising that the exposition turned out to be difficult, because this is a remarkably ambitious book. In effect, it tackles four topics, each one of them worthy of a separate volume or two.
One, it proposes a concept – reflexivity – to explain the relationship between thought and reality, and applies it to markets. Two, it presents Mr. Soros’s reasoning and actions in his laboratory, Quantum Fund, as an example. Three, it criticizes orthodox economics, in particular the central tenet of market equilibrium. And four, it draws implications for government policy.
These four themes–namely philosophy, investment practice, critique and economic policy–interact in an effort to “lay the groundwork for a new paradigm that is applicable not only to financial markets but to all social phenomena,” as Mr. Soros describes his challenging quest.
Reflexivity denotes a feedback loop: Individuals act on their views of a situation, thereby changing the situation. For example, if traders believe a stock is going up, they buy it, thereby bidding it up. But their belief caused the result; there may be no fundamental reason for the rise. Then there are unintended consequences: After becoming over-valued, the stock collapses.
Mr. Soros argues that expectations should be taken into account as part of reality because they affect it, but they do not necessarily correspond to reality. In other words, what we think determines what we do, but typically it is not correct.
Inspired by Heisenberg’s rule about quantum particles, he proclaims a human uncertainty principle that suggests our understanding is often incoherent and always incomplete. From the case study described below, one notices that uncertainty continually besets Mr. Soros in managing his hedge fund, which has the same name as the particles subject to Heisenberg’s uncertainty principle.