In his book – The Alchemy of Finance, George Soros discusses why he always starts with a view that market prices are wrong in the sense that they present a biased view of the future. Here’s an excerpt from the book:
When I became a fund manager I was putting my money where my mouth was and I could not afford to dissociate myself from my investment decisions.
I had to use all my intellectual resources and I discovered to my great surprise and gratification that my abstract ideas came in very handy. It would be an exaggeration to say that they accounted for my success but there can be no doubt that they gave me an edge.
I developed my own peculiar approach to investing which was at loggerheads with the prevailing wisdom. The generally accepted view is that markets are always right, that is market prices tend to discount future developments accurately, even when it is unclear what those developments are.
I start with the opposite point of view. 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.
This may create the impression that markets anticipate future developments accurately but in fact it is not present expectations that correspond to future events but future events that are shaped by present expectations.
The participants perceptions are inherently flawed and there is a two-way connection between flawed perceptions and the actual course of events which results in a lack of correspondence between the two.
I call this two-way connection ‘reflexivity’. In the course of my investment activities I discovered that financial markets operate on a principle that is somehow akin to scientific method.
Making an investment decision is like formulating a scientific hypothesis and submitting it to a practical test. The main difference is that the hypothesis that underlies an investment decision is intended to make money and not to establish a universally valid generalization both activities involve significant risk and success brings a corresponding reward.
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