George Soros is a living legend among traders. With a net worth of $28 Billion, he is the richest market speculator in the world, after Buffett. What’s interesting is that he started his hedge fund when he was 42 years old. His proteges share that his batting average is terrible. They say he has been right about 30% of the time, but when he is right, he’s right and he makes sure to fully capitalize on it. His trading philosophy could be best described with two phrases:
“It doesn’t matter if you are right or wrong, but how much money you make when you are right, and how much money you lose when you are wrong”
“When you have a tremendous conviction on a trade, you have to go for the jugular. When you are right on something, you can’t own enough”.
Here are a few more tidbits that reveal how Soros thinks about financial markets:
Perceptions affect prices and prices affect perceptions
I believe that market prices are always wrong in the sense that they present a biased view of the future. But distortion works in both directions: not only do market participants operate with a bias, but their bias can also influence the course of events.
For instance, the stock market is generally believed to anticipate recessions, it would be more correct to say that it can help to precipitate them. Thus I replace the assertion that markets are always right with two others: I) Markets are always biased in one direction or another; II) Markets can influence the events that they anticipate.
As long as the bias is self-reinforcing, expectations rise even faster than stock prices.
Nowhere is the role of expectations more clearly visible than in financial markets. Buy and sell decisions are based on expectations about future prices, and future prices, in turn are contingent on present buy and sell decisions.
Fundamental analysis seeks to establish how underlying values are reflected in stock prices, whereas the theory of reflexivity shows how stock prices can influence underlying values. One provides a static picture, the other a dynamic one.
Financial markets do not play a purely passive role; they can also affect the so-called fundamentals they are supposed to reflect. These two functions, that financial markets perform, work in opposite directions. In the passive or cognitive function, the fundamentals are supposed to determine market prices. In the active or manipulative function market, prices find ways of influencing the fundamentals. When both functions operate at the same time, they interfere with each other. The supposedly independent variable of one function is the dependent variable of the other, so that neither function has a truly independent variable. As a result, neither market prices nor the underlying reality is fully determined. Both suffer from an element of uncertainty that cannot be quantified.
When I see a bubble forming, I rush in to buy, adding fuel to the fire. That is not irrational.
Boom-bust processes are asymmetric in shape: a long, gradually accelerating boom is followed by a short and sharp bust. The bust is short and steep because it involves the forced liquidation of unsound positions.
First, financial markets, far from accurately reflecting all the available knowledge, always provide a distorted view of reality. The degree of distortion may vary from time to time. Sometimes it’s quite insignificant, at other times, it is quite pronounced. When there is a significant divergence between market prices and the underlying reality, there is a lack of equilibrium conditions.
I have developed a rudimentary theory of bubbles along these lines. Every bubble has two components: an underlying trend that prevails in reality and a misconception relating to that trend. When a positive feedback develops between the trend and the misconception, a boom-bust process is set in motion. The process is liable to be tested by negative feedback along the way, and if it is strong enough to survive these tests, both the trend and the misconception will be reinforced. Eventually, market expectations become so far removed from reality that people are forced to recognize that a misconception is involved. A twilight period ensues during which doubts grow and more and more people lose faith, but the prevailing trend is sustained by inertia.As Chuck Prince, former head of Citigroup, said, ‘As long as the music is playing, you’ve got to get up and dance. We are still dancing.’ Eventually, a tipping point is reached when the trend is reversed; it then becomes self-reinforcing in the opposite direction.
On trend following
Once a trend is established it tends to persist and to run its full course.
Currency movements tend to overshoot because of trend-following speculation, and we can observe similar trend-following behaviour in stock, commodity and real estate markets, of which Dutch Tulip Mania was the prototype.
When a long-term trend loses its momentum, short-term volatility tends to rise. It is easy to see why that should be so: the trend-following crowd is disoriented.
Markets might be forward-looking, but they are not always right
How good are markets at predicting real-world developments? Reading the record, it is striking how many calamities that I anticipated did not in fact materialise.
Financial markets constantly anticipate events, both on the positive and on the negative side, which fail to materialise exactly because they have been anticipated.
It is an old joke that the stock market has predicted seven of the last two recessions. Markets are often wrong.
It doesn’t hurt you what you don’t know, but what you think you know, when it ain’t so
Participants act not on the basis of their best interests but on their perception of their best interests, and the two are not identical.
I want to buy $300 million of bonds, so start by selling $50 million. I want to see what the market feels like first.
On how to be selectively active
The trouble with you, Byron [Byron Wein – Morgan Stanley], is that you go to work every day [and think] you should do something. I don’t, I only go to work on the days that make sense to go to work. And I really do something on that day. But you go to work and you do something every day and you don’t realise when it’s a special day.