Theory of Reflexivity
George Soros’ Theory of Reflexivity simply states that investors don't base their decisions on reality, but rather on their perceptions of reality. The theory of reflexivity has its roots in sociology, but in the world of economics and finance, its primary proponent is world-famous investor George Soros. His theory of reflexivity runs counter to the concepts of economic equilibrium, rational expectations, and the efficient market hypothesis. According to him, investors base their decisions more on how they perceive reality than on reality. As a result, there is a self-fulfilling loop in which traders’ views affect the underlying principles of economic activity, impacting traders’ perceptions. At its core, reflexivity proposes that subjective perception and objective reality interact in a dynamic feedback loop, especially in systems involving thinking participants—such as humans in financial markets, politics, or society at large.
The Theory of Reflexivity is a concept primarily applied in economics, finance, and social sciences.
The theory is well-positioned to explain the boom-and-bust pattern that has played out throughout history in asset prices.
It challenges the traditional assumption that markets (and social systems in general) move toward equilibrium based purely on rational expectations and objective realities.
It is based on the idea that feedback loops between expectations and economic fundamentals can cause price changes that substantially and persistently deviate from equilibrium prices.
EXAMPLE IN FINANCIAL MARKETS
Belief: Housing prices always rise.
Feedback: Rising prices reinforced belief → bubble.
Outcome: Belief collapsed → crash.
Dot-Com Bubble (2000)
Action: Overinvestment in unprofitable tech firms.
Feedback: Skyrocketing stock prices drew in more investors.
Outcome: Valuations crashed when profits didn’t follow.
Black Wednesday (1992)
Action: Massive shorting by speculators.
Outcome: UK exited ERM, pound collapsed, Soros profited.
Bitcoin & Crypto Booms
Belief: Crypto is the future, prices will rise.
Action: Herd buying, media hype.
Feedback: Prices rise → more belief → more buying.
Outcome: Volatility and major crashes after sentiment shifts.
GameStop / Meme Stocks (2021)