A brief discussion on the reflexivity of the market: a self-fulfilling prophecy of investment

The market does not simply follow objective laws, but is influenced by investors subjective consciousness and expectations.

When we talk about value investing, there is such a situation: when investors find that the price of a project they are optimistic about has risen, they feel that they have made money and even see people around them making profits, so they will be more willing to invest more money. This optimism not only benefits investors, but also makes the project parties profitable. The rise in the projects coin price also makes the project party make money, and at this time, analysts will promptly release various favorable reports, emphasizing the fundamental advantages of the project, it is an unprecedented innovation, etc., to further encourage investors to buy. This atmosphere will push up the coin price, and the rise in the coin price, in turn, verifies the confidence of investors and project parties, forming a self-reinforcing feedback loop.

This is a vivid interpretation of George Soross reflexivity theory in the capital market. The market does not simply follow objective laws, but is influenced by investors subjective consciousness and expectations. The fluctuation of market prices not only affects investors views, but these views can also react to the market, forming a cycle. This is a typical process of cognition and reality influencing each other, which is also what we say cognition changes reality, and reality changes cognition.

What is reflexivity?

Reflexivity comes from the English word reflexivity and is widely used in modern humanities and social sciences. It refers to a more structured self-reflection process, which is different from reflection in the general sense. This concept emphasizes self-reference and deep self-reflection.

Soross reflexivity principle explains the close connection between our thinking and reality. In this theory, the way an individual thinks can directly affect the reality. For example, when you determine that the market has entered a bull market, this judgment is not just an opinion, but an attitude. This attitude is invisibly transmitted between investors and the market. The market receives the high emotions and buying behavior from investors, thus forming a bull market. Influenced by the optimistic sentiment of the bull market, investors will reflexively project more buying behavior to the market, which further strengthens more investors judgment of the bull market signal and deepens peoples confidence that the market is a bull market.

This positive signal will immediately activate the market reaction, and the market will give you more emotional incentives. This incentive and a series of market-related reactions will further confirm the investors judgment and make them more convinced that this is a good signal: I need to increase investment to obtain greater benefits.

Over time, investors behaviors and attitudes are amplified in the market, and the interaction between the two parties shapes a mapping game. In the end, they become more and more convinced that their initial judgment is correct. This self-confirming cycle allows the market to continue to develop in line with investors optimistic expectations. In this way, observers and market participants are involved in a self-fulfilling cycle, and the market eventually behaves as expected.

Self-fulfilling prophecy

Soros believes that investors in the financial market cannot obtain complete information, so they will form investment biases. These biases are the fundamental driving force of the financial market. They will continue to strengthen in the market and produce group influence, triggering the butterfly effect, pushing the market in a single direction, and finally leading to a market reversal. This is called a self-fulfilling prophecy in the capital market.

Soros investment philosophy is based on a basic assumption that the market is always wrong. But he has a systematic theory to explain why the market is wrong. This theory is crucial for him to profit from the markets mistakes.

So, how do we understand this reflexivity theory? Changes in market prices will trigger changes in market prices, which is a self-reinforcing cycle. Using this theory, we can discover over-reacting markets, track the process of the market forming a trend, self-promoting and strengthening, and finally declining, and capture its turning point, which is precisely the investment opportunity that can obtain the greatest benefits.

Here is an example of a common phenomenon we see in investment:

When we see the Ethereum Foundation selling coins, we have the impression that they often sell at the top of the mountain. Investors will think this is a sell signal, so followers flock in and sell in panic, which becomes a trend behavior that cannot be reversed, thus forming a strong consensus – Ethereum cant hold on. There are many similar phenomena. A simple wallet sorting behavior by the project party will also be understood as selling, triggering a series of butterfly effects later, causing the price of the coin to collapse. This situation is not uncommon.

The reason behind this phenomenon is the mainstream bias formed by following the trend. Its driving force on the market is the main reason for the formation of an overreactive market. Although the actions of followers are somewhat blind, they can strengthen the markets own trend. Due to the complexity of market factors, the more uncertain factors there are, the more followers there are, and the greater the impact of this speculative behavior of following the trend. In fact, this influence itself has become one of the fundamental factors that influence the market trend.

This is why price results often deviate from macro forecasts:

In the crypto market, investor sentiment and market perception have a direct impact on price. If investors generally believe that a particular cryptocurrency will increase in value, they may buy it in large quantities, driving the price up. This price increase further reinforces this belief, attracting more investors to the market. Its a feedback loop of perception and behavior.

In addition, due to the rapid and complex dissemination of market information, market participants often make decisions based on incomplete or distorted information. This information asymmetry may lead to an unbalanced market and cause short-term sharp price fluctuations. This is also what Soros mentioned about the lack of market information and asymmetry .

Reflexivity also manifests itself in the crypto market through group behavior. For example, when a large number of investors react in the same way to a piece of news or an event, the market tends to fluctuate violently, a phenomenon that is particularly common among so-called whale investors. Eventually, the market bubble caused by reflexivity will be corrected and adjusted. Overly optimistic market sentiment may push crypto assets far beyond their true value. When the market realizes this, there will be a sharp correction, and prices will fall back to more sustainable levels.

This reminds me of our discussion in August on the expectations of rate cuts and the possibility of recession, and the impact of a 25 basis point or 50 basis point cut. (Links: https://x.com/XTExchangecn/status/1823552350260486244)

We talked about how the Fed shifted from a tight policy to fight inflation to a relatively loose stance to prevent potential weakness in employment after the first rate cut in September. This marked a shift in market focus from inflation to the labor market, which is a key indicator of whether the market is in recession.

The prediction at the time was: If the interest rate is cut by 25 basis points, it will support the argument of defensive rate cuts and prove that the US economy is still healthy. But if the interest rate is cut by 50 basis points, the market may rebound sharply for a short time, but it also means that the Fed is saving the market and the risk of recession is approaching.

However, the actual market reaction after the rate cut was different from expectations. With a 50 basis point rate cut, the market ushered in a solid rebound instead of a recession panic, and the current BTC price bottom is also being raised. The general view of rational investors is that the global easing policy will only bring short-term economic prosperity, which will lead to instability in the stock market in the later stage and even increase the risk of recession. Therefore, investors need to remain vigilant and optimistic. Although many rational investors are pessimistic, they cannot resist the influence of most optimistic investors. These optimists believe that the benefits brought by global easing and the crazy rise of the stock market will correct the excessive panic caused by the recession and Sams Law, making investors cautiously optimistic about the future market. The market trend is indeed affected by investor behavior, and analysts forecasts will also be corrected by the real-time market trend. This is an interactive reflexive relationship, and the interaction between investors and the market will ultimately determine the market trend.

Investors behavior depends largely on their experience. If they have made money in the market, they will be optimistic about almost everything. For example, if a person gets positive feedback at work, such as a promotion and salary increase, he will feel more confident and optimistic, and it will be easier for him to succeed in other things when he is in a good state. On the contrary, if a person has encountered many setbacks recently, his self-efficacy will be reduced, making more wrong decisions and even falling into self-doubt.

The same is true in the financial market. After investors receive huge returns, people are often more willing to increase their investment and believe that they are in a good market because of positive feedback. Soros once said: Each of us has a flawed and distorted worldview, so our understanding of reality is incomplete. The market is often influenced by investors exaggerated biases. This also explains why investors are so easily affected by market sentiment and have difficulty making rational judgments.

The market always swings between two extremes, one is distortion carnival and the other is correction of errors . Short-term market deviations will always be corrected. What investors need to do is to seize the opportunity and leave the market in time before most people are still immersed in optimism. Otherwise, it will be too late when they realize their mistakes.

Soros developed an investment strategy based on this understanding of peoples incomplete understanding of reality. He believes that our incomplete understanding is a factor that affects events, and events affected by distorted understanding in turn affect our understanding. This process is a reflexive process. Investors need to be vigilant about this reflexivity at all times to avoid being swayed by market sentiment.

We can further break down the deduction of reflexivity theory:

1. The first step is background preset:

The market trend is not yet clear, and investors are waiting for clear signals. For example, after the sharp drop in August, before the extent of the US interest rate cut in September is determined, the market trend has not yet been determined. This is a background preset process.

2. Then carve the crystal ball:

After the rate cut was implemented, investors attitudes swung back and forth, and polarization continued to emerge. Some people believed that the rate cut would lead to a large amount of money being released, which would benefit the risk market overall, while others believed that the Sams Law was triggered, and a 50 basis point rate cut meant that a recession with greater risks was coming. Investors seemed to be carving their own crystal balls, projecting their thoughts into the ball, and the ball would also reflect the investors behavior and thoughts truthfully.

3. The crystal ball reflects the results and maps the market:

Eventually, a trend is identified and the market gets a successful test upwards. This test is not recognized by everyone at the beginning. As the market trends and more people profit, this upward result is tested over and over again through various shocks. This recognition will strengthen the development of the upward trend and lead to the beginning of a self-propelling process.

4. Speed up the process:

As trends and biased ideas promote each other, biases are increasingly exaggerated. When this process develops to a certain stage, the degree of certainty is further increased. The interaction between the two makes investors fall into blind mania. The stronger the trend, the further the bias deviates from the truth. In fact, at this time, the market hides the fragility that can be corrected at any time.

5. Market formation bias and cognitive bias:

Investors over-relied on and exaggerated the test results, to the point that they formed a belief that deviated too much from reality. The bias of market participants became obvious. After the carnival reached a climax, peoples views on the market began to have limited driving effect, the original trend stagnated, and another voice began to influence the market.

6. Corrections:

After the emergence of another voice, the original market confidence began to lose, and the market began to switch to the opposite direction. This switching point is called the intersection point. The ultimate result of the market with an overreaction is the occurrence of the phenomenon of prosperity and decline.

Summarize

Soross reflexivity theory challenges the traditional efficient market hypothesis and emphasizes the incomplete efficiency and dynamics of the market. Investors expectations and behaviors will in turn affect market trends, forming a complex feedback mechanism. This theory provides a new perspective for understanding the complexity and volatility of financial markets and also provides good opportunities for value investors.

Recently, the US stock market hit a new record high, driving a full rebound in the crypto market. After the release of the September CPI data, market confidence was significantly boosted, and the financial performance of major banks also stimulated the enthusiasm of traders. JPMorgan Chase even stated that the United States has now reached a lower inflation target, the economy has also achieved healthy growth, and achieved the widely discussed soft landing. At present, the market has entered a generally optimistic atmosphere. Inspired by this positive sentiment, it will undoubtedly reflect more positive signals in the short term and act positively on the market again. Optimism is like a snowball, and it is expected that the momentum to push the market upward will become stronger and stronger.

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銆怐isclaimer銆慣his article is for reference only and does not constitute any investment advice. Investment involves risks, please operate with caution. Readers should independently evaluate the content of this article based on their own circumstances and bear the risks and consequences of investment decisions.

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