# Understanding Reflexivity Theory: George Soros' Market Impact

## What Is Reflexivity?

Reflexivity refers to a theory in economics where investors' perceptions influence economic fundamentals and in turn, those perceptions and market prices. Reflexivity originates in sociology, but it is prominent in the field of finance. [George Soros](https://www.investopedia.com/terms/g/soros.asp), its leading advocate, believes that the deviations from economic equilibrium are due to positive feedback loops. According to Soros, reflexivity theory challenges equilibrium and the efficient market hypothesis.

### Key Takeaways

*   Reflexivity suggests that investors' perceptions can impact market fundamentals, creating feedback loops that affect perceptions and prices.
*   George Soros is the foremost advocate of reflexivity, leveraging it in his investment strategy to account for market deviations from equilibrium.
*   Reflexivity challenges mainstream theories like economic equilibrium and the efficient market hypothesis by highlighting persistent price deviations.
*   Reflexivity-driven cycles, such as booms and busts, demonstrate how positive feedback loops can lead to significant economic impacts like financial crises.
*   Soros contends that reflexivity leads to price movements driven by leverage and credit, making markets susceptible to bubbles and corrections.

## Reflexivity's Challenge to Economic Equilibrium

Reflexivity theory states that investors don't base their decisions on reality, but rather on their perceptions of reality instead. The actions that result from these perceptions have an impact on reality, or fundamentals, which then affects investors' perceptions and thus prices. The process is self-reinforcing and tends toward [disequilibrium](https://www.investopedia.com/terms/d/disequilibrium.asp), causing prices to become increasingly detached from reality. Soros sees the global financial crisis as an example of reflexivity. In his view, rising home prices induced banks to increase their home mortgage lending and, in turn, increased lending helped drive up home prices. Unchecked rising prices created a bubble that eventually burst, leading to the financial crisis and [Great Recession](https://www.investopedia.com/terms/g/great-recession.asp).

Soros's reflexivity theory opposes economic [equilibrium](https://www.investopedia.com/terms/e/economic-equilibrium.asp), [rational expectations](https://www.investopedia.com/terms/r/rationaltheoryofexpectations.asp), and the [efficient market hypothesis](https://www.investopedia.com/terms/e/efficientmarkethypothesis.asp). Mainstream economics suggests that real fundamentals, like [supply and demand](https://www.investopedia.com/terms/l/law-of-supply-demand.asp), imply equilibrium prices. Changes in fundamentals, like consumer preferences and scarcity, cause markets to adjust prices based on expectations. This process includes both [positive](https://www.investopedia.com/terms/p/positive-feedback.asp) and [negative](https://www.investopedia.com/terms/n/negative-feedback.asp) feedback between prices and expectations regarding economic fundamentals, which balance each other out at a new equilibrium price. In the absence of major obstacles to communicating information regarding economic fundamentals and engaging in transactions at mutually agreed prices, this price process will tend to keep the market moving quickly and efficiently toward equilibrium.

Soros thinks reflexivity challenges equilibrium because prices can significantly and persistently deviate from it. ISoros believes price formation is reflexive, driven by feedback loops between prices and expectations. Once a change in economic fundamentals occurs, these positive feedback loops cause prices to under- or overshoot the new equilibrium. In some way, the normal negative feedback between prices and expectations regarding economic fundamentals, which would counterbalance these positive feedback loops, fails. Eventually, the trend reverses once market participants recognize that prices have become detached from reality and revise their expectations (though Soros does not recognize this as negative feedback).

Soros uses the boom-bust cycle and price bubbles, followed by crashes, to support his theory, noting they show prices straying from equilibrium. He often refers to the use of leverage and the availability of credit in initiating the process, and the role of floating currency exchange rates in these episodes.

## The Bottom Line

Reflexivity is an economic theory advocated by George Soros, the central idea of which is that feedback loops between investor perceptions and economic fundamentals prevent markets from reaching equilibrium. Reflexivity can lead to significant price deviations from fundamental values through positive feedback loops, citing historical financial crises such as the global financial crisis. Reflexivity provides a different perspective on price trends and market behavior, valuing investor perceptions as a crucial factor affecting economic conditions. It can impact market behavior and result in increased volatility due to the disconnect between prices and economic reality. Investors may wish to consider reflexivity when making investment decisions. Be sure to consult with a financial advisor if you have any questions.

> **Article Sources**
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> 1.  Soros, George, via eMacromall.com. "[The Theory of Reflexivity](https://emacromall.com/reference/George-Soros.pdf)," Page 3.
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> 2.  Soros, George. "[Fallibility, Reflexivity, and the Human Uncertainty Principle](https://www.tandfonline.com/doi/full/10.1080/1350178X.2013.859415)." _Journal of Economic Methodology_, vol. 20, no. 4, January 2014, pp. 309-329.
>     
> 3.  ILMR Editors. "[George Soros' New Paradigm for Financial Markets](https://digitalcommons.law.byu.edu/cgi/viewcontent.cgi?article=1063&context=ilmr)." _Brigham Young University International Law & Management Review_, vol. 5, no. 2, May 2009, pp. 273-285.