Book Review

“The Alchemy of Finance,” by George Soros, Hoboken, N.J.; John Wiley & Sons Inc., 2003; 391 pages, US$19.95.

NEW YORK (– 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.

Uncertainty Principle

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.

For markets in general, this perspective provides a ready explanation for boom/bust sequences and financial crises. Mr. Soros rails against equilibrium-centered traditional economics for its inability to deal with such realities, and encourages alternative lines of inquiry. In recent years behavioral finance, a new type of economics based on a realistic depiction of human behavior, has developed explanations consistent with the Soros approach.

Trial and Error

General models do not always translate into money-making practice. For instance, Mr. Soros lost money in the 1990s technology bubble despite being familiar with boom/bust cycles. But his philosophical musings provide one insight of great practical significance: Traders need to be adaptive because there is no way of knowing beforehand how a market situation will turn out.

The Quantum Fund experience demonstrates how that works. Mr. Soros recorded the investment decisions he made from August 1985 through November 1986, at the time he made them. This remains a fascinating exercise in global macro strategy; a master speculator’s take on commodity, currency and equity markets.

His account is a litany of doubts, hazards and mistakes. He is skeptical of a widespread thesis that the economy is strengthening but is not sure. He is short the dollar but is afraid of the risk. He is carrying a short position in oil, and it is getting expensive. At one point he writes, “My crystal ball is cloudy.”

He’s been losing on currency trades for several years. Then in September 1985, he makes a killing by buying a lot of yen just before central banks switch to a new exchange rate system and the yen rises. There is a pattern: He sustains losses, reduces positions, gets out, then sees a great opportunity and pounces. In short, he constantly and quickly adapts to events.

In January 1986, stock and bond markets collapse, mauling his portfolio. He pulls back, but by March feels he moved too soon to reduce leverage, thereby missing the best of a bond rally. Despite various setbacks and doubts that were sometimes paralyzing, Quantum Fund’s NAV per share rose 121% in 1985 and 43% in 1986. Such numbers make for legend and Mr. Soros became one.

How did he do it? He keeps an open mind and continually modifies his outlook with new information. As he says, “the markets provide a merciless reality check,” and Mr. Soros never stays with an idea that fails the test. Most of the time he can’t predict what’s coming, but he promptly corrects course in response to feedback. That limits losses. On rare occasions he can see through the fog of uncertainty and hauls in the booty.

He learns what the market has to say and then beats it by understanding the message. “The main difference between me and the markets is that markets seem to engage in a process of trial and error without the participants fully understanding what is going on, while I do it consciously,” he says.

This is not an easy book to read, but as another hedge fund manager describes it in the foreword, it is a timeless guide. “When I enter the inevitable losing streak that befalls every investor, I pick up ‘The Alchemy’ and revisit Mr. Soros’s campaigns,” writes Paul Tudor Jones.