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Soros Investment Theory

George Soros, a Hungarian-born Jew, graduated from the London School of Economics and moved to the United States in 1956. He founded the Quantum Fund in 1969 and achieved great success. He later established a series of foundations dedicated to open society and philanthropy. Briefly: Soros is a legendary figure who experienced hardship as a child, and his survival instincts are ingrained in his hedge fund operations; influenced by Popper during his studies, he developed a love for philosophy, allowing him to understand the shortcomings of market economics (mechanisms) as a whole and to profit from the mistakes of his opponents in trading; his trading cannot be imitated, only learned from and appreciated, showcasing a distinct personal style.

1. In "The Alchemy of Finance," I wrote: "This book represents the struggle of my life."

2. The concept of reflexivity is actually quite simple: in any situation involving thinking participants, there exists a mutual influence between the participants' thoughts and the reality of the situation.

3. Traditional theories that conform to truth believe that knowledge is expressed through true propositions: a proposition x is true if and only if the fact it describes actually occurs. Such facts must be independent of the proposition to constitute a credible judgment.

Comment: A more accurate statement is that facts are at least not influenced by the proposition.

Another comment: In the social realm, it is precisely the opposite; propositions and facts always influence each other. Moreover, propositions that influence facts are good propositions. However, good propositions are not necessarily true.

4. The participants' imperfect understanding of facts leads to their actions potentially causing unforeseen consequences.

5. This book will detail many specific examples to discuss how popular trends prove their own validity. Once a certain limit is exceeded, this self-reinforcing feedback loop becomes difficult to maintain.

6. Our view of the world is part of the real world—we are participants.

7. "The Principle of Human Uncertainty." This principle states that people's understanding of the world they live in cannot simultaneously satisfy truth, completeness, and coherence.

8. I believe that the theory of equilibrium applicable to financial markets is an illusion. This theory originates from its success in natural sciences, so economic theories attempt to mimic Newtonian mechanics. It tries to establish universally valid paradigms under equilibrium conditions, as long as its analysis is confined to the material world without other disturbances, it is broadly successful.

9. Credit cannot merely be seen as a reflection of underlying supply and demand relationships, as it is an active factor shaping those relationships.

10. In pure exchange, equilibrium has a definite definition, namely clear market prices. When applied to financial markets, equilibrium becomes more of a theoretical concept.

Comment: Reality is not always balanced; financial markets are often extreme. This does not prevent a sense of balance, a perspective of balance, or balanced thinking.

In sociology, socialization (modern English; or socialisation - see [spelling differences]) is the process of internalizing social norms and ideologies. Socialization includes learning and teaching, thus serving as a means to achieve social and cultural continuity.

Socialization is closely related to developmental psychology and behaviorism. Humans need social experiences to learn their culture and survive.

Socialization essentially represents a learning process throughout the life course, having a core influence on the behavior, beliefs, and actions of both adults and children.

Socialization may lead to ideal outcomes—sometimes referred to as "morality"—in terms of the society in which it occurs. Individual perspectives are influenced by social consensus, often leaning towards views considered acceptable or "normal" by society. Socialization can only partially explain human beliefs and behaviors, positing that the subject is not predetermined by their environment (nature versus nurture); scientific research provides evidence that people are shaped by both social influences and genetics.

Genetic studies indicate that a person's environment interacts with their genotype, thereby affecting behavioral outcomes.

This is the process by which individuals learn their own social culture.

In epistemology, more specifically in the sociology of knowledge, reflexivity refers to the cyclical relationship between cause and effect, especially the causal relationships embedded in human belief structures. When causes and effects influence reflexive subjects within layered or complex social relationships, reflexive relationships are multidirectional. When epistemology includes religion, the complexity of this relationship increases further.

In broader sociology (the field of origin), reflexivity refers to a self-referential behavior where there exists a trigger for examination, through which cognitive behavior "turns," refers to, and influences the entities that trigger the action or examination. It often refers to the subject's ability to identify socializing forces and change their position within the social structure. Low levels of reflexivity lead individuals to be largely influenced by their environment (or "society"). High levels of social reflexivity will be defined by individuals shaping their own norms, tastes, politics, desires, etc. This is similar to the concept of autonomy.

In economics, reflexivity refers to the self-reinforcing effects of market sentiment, where rising prices attract buyers, and the behavior of buyers further drives up prices until the process becomes unsustainable. This is an example of a positive feedback loop. The same process can run in reverse, leading to catastrophic price drops.

Reflexivity
Reflexivity typically refers to the examination of one's own beliefs, judgments, and practices during the research process, as well as how these beliefs, judgments, and practices affect the research. If positionality refers to what we know and believe, then reflexivity refers to what we do with that knowledge. Reflexivity involves questioning the assumptions we take for granted. Essentially, it involves drawing attention to the researcher rather than "covering up" the researcher and pretending that the researcher has no impact. It requires an open attitude and acceptance that the researcher is part of the research (Finlay 1998).

Reflexivity differs from "reflectivity": all researchers think and judge their data (e.g., "Does the data suggest a certain conclusion?"); whereas reflexivity steps back to examine the person making the judgment ("Am I the kind of person who tends to believe the data suggests this conclusion?"). Different research traditions have different views on reflexivity and positionality. Positivism, in attempting to mimic the methods of natural sciences, adopts a third-person narrative, creating the myth of value-neutral research. Of course, this does not mean that positivist researchers fail to reflect on their data or lack reflexivity; they may have engaged in long and deep reflection on their positionality but accepted the convention of not discussing it. In more interpretive approaches, discussions of reflexivity may be encouraged, especially in longer, more personalized documents like theses, although there is no consensus on the form such discussions should take.

Reflexivity brings dilemmas and challenges. These issues often become explicit when there is a significant gap in background knowledge, behavior, and fundamental beliefs between the researcher and the researched, but they should be a universal consideration for all research. Personal positionality is increasingly placed within a broader context of social identity, so establishing rapport in interviews with people of different genders, races, ages, or sexual orientations is more important than demonstrating an open-minded and unbiased attitude; whatever you do, there will be deeper forces determining your interactions. Reflexive checks should extend beyond behavior in research projects and consider the positionality of the broader research discipline. This can encompass what is taken for granted in problem definition, which research questions tend to be included or excluded, whether there are restrictive dominant paradigms, or even liberal orthodoxy or cultural relativism, where "anything can happen." Like positionality, discussions of reflexivity have been criticized as narcissistic and self-indulgent; it is important to remember that the reader's interest in the researcher may be far less than the researcher's interest in the research. Discussions of reflexivity may also lead to a paralysis (Johnson and Duberley 2003), as each judgment is nested within layers of personal and disciplinary reference frameworks. One way to address these difficulties is to bring discussions of reflexivity back to specific issues in the research, where the researcher may wish to illustrate interpretive patterns rather than describe every reflexive judgment. Reflexivity should be seen as a virtue rather than a vice. Winter (1989) likens research to a detective story, where the detective learns about themselves through solving the case. This metaphor was proposed in the context of action research but is undoubtedly a broader comment on the humanistic nature of reflexive judgment.

1. The Idea of Radical Fallibility#

Human understanding of the world we inhabit is inherently incomplete, meaning there is always a distortion between people's thinking and objective reality; no one in the world can claim to possess ultimate truth.

All constructions of the human mind, whether limited to the depths of our thinking or manifested as various disciplines, ideologies, or systems, are flawed. Here, flawed does not mean "potentially fallible," but rather "certainly fallible."

If we acknowledge that there is always a gap (distortion) between objective reality and our understanding of it, then recognizing this gap and its implications becomes significant. This notion suggests that even in natural sciences, it is impossible to absolutely distinguish between thought and reality, especially in understanding social phenomena. Furthermore, it should be recognized that human thinking generally has a dual role:

• On one hand, it passively reflects the reality that thinking activities seek to understand to some extent.
• On the other hand, the results of thinking can also become components of reality itself, more or less.

Therefore, there is no knowledge that absolutely reflects objective reality.

The idea of radical fallibility has a very positive and enlightening aspect; it opens the door to our critical rational thinking, implying that our understanding of objective reality has infinite space, and our thinking or society has unlimited room for improvement and development. In practical action, the idea of fallibility encourages us to seek out the flaws in every situation and benefit from identifying those flaws.

Although financial investors have attempted countless times to use models and theories to deduce market developments, "to reduce the information encountered to a manageable level, various techniques must be employed, which distort the information being processed and may even complicate reality, making understanding more difficult." Thus, we find that even the most classical pricing theories and the most powerful indicators often serve more as "reference values" in actual investment processes; they cannot fully align with the final facts, which is the reality of the idea of fallibility.

Therefore, the first principle of radical fallibility theory is the courageous acknowledgment of the normalcy of error; error is a norm and an unavoidable fact.

Human understanding is inherently imperfect because humans are part of reality, and the part cannot fully comprehend the whole. The human brain has a limited capacity to process information, while the information that needs to be processed is, in fact, infinite. We do not truly understand the world we inhabit. At the same time, people's erroneous perceptions of the world also affect the world, and the two are not completely independent.

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2. Reflexivity Theory#

Reflexivity theory refers to the interactive relationship between investors and financial markets, where investors form expectations about the market based on the information they acquire and take action, which in turn alters the original development direction of the market, reflecting a new market form and continuing to change the trajectory of the financial market.

It can be said that such reflexive connections exist universally across various fields of human activity, including politics, economics, and history.

Specifically, reflexivity has two meanings:

• First, current biases affect prices.
• Second, under certain circumstances, current biases can also influence fundamentals, leading to further changes in market prices.

Markets are not always correct; from the perspective of market prices reflecting future trends, markets are often wrong. The role of this error is twofold:

• On one hand, it leads to deviations in market participants' understanding of market expectations.
• On the other hand, this deviation also affects their investment activities, resulting in incorrect judgments about market development trends.

In other words, it is not that current expectations align with future situations, but rather that current expectations shape what happens in the future.

Market participants' understanding of the market is inherently flawed; this flawed understanding is interconnected with what actually occurs, and the two are not completely independent but interact and determine each other.

Through this two-way connection, participants' thoughts influence their circumstances and experiences, shaping a dynamic relationship that is unpredictable.

Since investors cannot obtain complete information, and individual issues can influence their understanding of the market, leading to differing opinions on market expectations, these differing opinions constitute "investment biases." Investment biases are the fundamental driving force of financial markets. When investment biases are scattered, their influence on financial markets is minimal; when investment biases are continuously reinforced through interaction and create a collective impact, they can produce a "butterfly effect," pushing the market in a single direction, ultimately leading to a reversal.

Once people begin to engage in thinking about a phenomenon, the decisive factors of that phenomenon are no longer just the phenomenon itself, but also include people's perspectives. Thus, the development process of a phenomenon is not a direct leap from one event to another, but rather a transition from fact to perspective, and then from perspective back to fact.

The reciprocal feedback between understanding and reality causes a process to occur:

• First, self-reinforcement and continuous development.
• Then, a peak period emerges.
• Next, the situation deteriorates, showing a downward trend.
• Finally, a collapse occurs.

Regarding the principle of reflexivity, here are two examples from work and life.

Suppose there is a cup of water that is about to fall off the table due to a strong wind. At this moment, you foresee the trend of the cup falling and reach out to support it, preventing the potential falling event. As a result, your expectation of the cup falling has altered the final outcome of that event. Therefore, it can be said that it was the expectation of the cup's imminent fall that prevented the cup from falling.

3. The Principle of Uncertainty#

Traditional scientific methodologies emphasize the relationship between scientific research and certainty, with certainty becoming a characteristic feature of judging science and truth. In a philosophical sense, this idea manifests as: only statements that can be judged as true or false are meaningful, while statements that are not true or false (uncertain) are meaningless.

However, in actual work, investment, and life, uncertainty phenomena are ubiquitous; they are not some mysterious new phenomenon but are rooted in common sense.

Traditional truth systems only emphasize two categories of true or false statements, but for a world that includes thinking individuals, this system is insufficient. We must acknowledge another category of truth, which is uncertain statements or reflexive statements whose real value depends on their impact. This is what is referred to as the third category of truth; the significance of reflexive phenomena constitutes an important meaning of the concept of truth: facts do not necessarily constitute the sole standard for judging truth.

Traditional views hold that the basis for judging truth is whether statements correspond to facts, but if we understand the reflexive view of truth, we can recognize that there are two ways to determine whether statements correspond to facts:

• One can present correct statements.
• But one can also influence facts through statements.

Karl Popper discussed in "The Open Society and Its Enemies" that empirical cognition cannot be absolutely certain; even scientific principles cannot be completely confirmed without a trace of doubt but can only be falsified through testing. A single failed test is sufficient to falsify, while more confirmatory examples cannot fully confirm. The characteristic of scientific principles is their hypothetical nature, and their truth must withstand the test of falsification.

Human thoughts are the most easily changeable, thus everything involving human participation has a degree of uncertainty due to human variability. A simple deterministic system (a bunch of rational people) can produce what appears to be a random process (the unpredictable speculative market).

4. The Theory of Rise and Fall#

1. Initial Stage: During this period, the future development trend of the financial market has not yet been fully determined. Popular trends and biases interact and complement each other.
2. Self-Reinforcing Stage: At this point, the trend has been established. Subsequently, everyone follows suit, and thus this established trend will be reinforced and begin to self-reinforce. As popular trends and people's biases mutually promote each other, the influence of biases on the trend increases. Consequently, the effect of biases becomes exaggerated, leading to an imbalance.
3. Testing Stage: The gap between biases and actual conditions grows larger, and thus the market development trend and people's biases may be subjected to various external shocks; this period is a testing stage for trends and biases.
4. Acceleration Stage: If after these tests, the trend and biases still exist as they did at the beginning, it indicates that they can withstand external shocks, thereby enhancing their credibility.
5. Peak Stage: As events develop, the truth gradually emerges, and a gap begins to appear between understanding and reality, widening the fissures. At this point, people's biases also become increasingly evident. This period is when the truth is revealed, and the development of events reaches its peak.
6. Decline Stage: After the peak period, like reflexivity, due to the effect of self-reinforcement, a reversal of the trend is inevitable. Events begin to move in the opposite direction, leading to a continuous rise or fall.

5. The Theory of Boom and Bust (Mutual Generation)#

The concept of mutual generation means that it starts with self-propulsion, then becomes difficult to maintain, ultimately leading to the opposite. Individuals with flawed perceptions cause the market to amplify their emotions, meaning that investors become trapped in a kind of blind frenzy or beast-like emotion, which is the herd effect.

The more uncertain factors there are in the market, the more people will flow with the market trend. The greater the impact of this instantaneous speculative behavior, the more uncertain the situation becomes. The way of investing is essentially betting on instability, searching for development trends that exceed expectations.

1. We do not truly understand the world we inhabit, which is the fallibility.
2. Our understanding of the world does not match reality, which is reflexivity.

After biases persist for a while, they form a mainstream force in the market, causing the trend to diverge further from reality, thus creating a larger herd effect. After this pattern expands repeatedly for a period, when the deviation becomes excessively obvious, the bubble will burst and return to reality.

Full text: Fallibility, reflexivity, and the principle of human uncertainty. I am honored that the editors of "Economic Methodology" have created this special issue...

Introduction#

I am honored that the editors of "Economic Methodology" have created this special issue on reflexivity and invited me and a group of distinguished scholars to contribute.

Of course, I am not the discoverer of reflexivity. Early observers have recognized it, or at least some aspects of it, but often under different names. Knight (1921) explored the distinction between risk and uncertainty. Keynes (1936, Chapter 12) likened financial markets to beauty contests, where participants must guess who the most popular choice is. Sociologist Merton (1949) wrote about self-fulfilling prophecies, unintended consequences, and the effects of the masses. Popper discussed the "Oedipus effect" in The Poverty of Historicism (1957, Chapter 5).

My own conceptual framework originated in the late 1950s when I was studying at the London School of Economics. I took my final exams a year early, so I had a year to fill before obtaining my degree. I chose my supervisor, and I chose Popper, whose work The Open Society and Its Enemies (1945) left a profound impression on me.

Popper's other great work, The Logic of Scientific Discovery (1935), was published in English as The Logic of Scientific Discovery (1959), where he argued that the possibility of empirical truth is determined to be absolutely equal. Even scientific logic cannot be confirmed without a trace of doubt: they can only be falsified through testing. A single failed test is sufficient to falsify, while more confirming instances cannot fully confirm. The characteristics of scientific principles are hypothetical; their truth must withstand the test of falsification.

While reading Popper, I was also studying economic theory. Popper emphasized imperfect understanding, while the theory of perfect competition in economics assumes perfect knowledge, and the contradiction between the two shocked me. This led me to begin questioning the assumptions of economic theory. This was one of the two major theoretical inspirations for my philosophy.

My experiences in life were shaped by the German occupation of Hungary in 1944. At that time, I was not yet 14 years old, coming from a relatively affluent middle-class background, but suddenly, just because I was Jewish, I faced the prospect of being expelled and killed.

Fortunately, my father was well-prepared for such extraordinary circumstances. He had experienced the Russian Revolution, which was a valuable experience in his life. Before that, he was an ambitious young man who volunteered for the Austro-Hungarian army when World War I broke out. He was captured by the Russians and sent to Siberia as a prisoner of war. Due to his ambition, he became the editor of a self-made newspaper by the prisoners. This newspaper was handwritten on a wooden board and was called "The Board." This job made him very popular, and he was elected as the representative of the prisoners. Later, some soldiers escaped from a nearby concentration camp, and the representative of that camp was executed in retaliation. My father did not want to sit and wait for the same thing to happen in his camp, so he organized a small group to lead an escape. His plan was to build a raft to sail into the sea, but his geographical knowledge was too lacking; he did not know that all rivers in Siberia flow toward the Arctic Ocean. They drifted for several weeks before realizing they were heading toward the Arctic Ocean and spent several months traversing dense coniferous forests to find their way back to civilization. Meanwhile, the Russian Revolution broke out, and they were caught up in it. After a series of adventures, my father finally returned to Hungary; had he stayed in the concentration camp, he would have been home much sooner.

When my father returned home, he had changed. The experiences during the Russian Revolution deeply affected him. He lost his ambition and wanted nothing more than to enjoy life. The values he imparted to his children were vastly different from those prevalent in our environment. He did not want to accumulate wealth or become a pillar of society; he just wanted to work and earn enough to get by. I remember once before a skiing holiday, he sent me to borrow money from one of his major clients, and afterward, my father was unhappy for several weeks because he had to work harder to pay it back. Although we lived relatively comfortably, we did not belong to a bourgeois family; we took pride in our uniqueness.

In 1944, when Germany occupied Hungary, my father immediately understood that this was not a normal time and that normal rules could not apply. He obtained false identification for his family and many others; some paid for it, while others received it for free. Most people escaped unharmed. Those were his best times.

Living under a false identity also became an exhilarating experience for me. We were in deadly danger, with people dying around us, but we not only survived but also helped others. We were in league with angels, overcoming the seemingly invincible demons. This made me feel special. What a high adventure! With my father as a reliable guide, I navigated through hardships smoothly. What more could a 14-year-old child ask for?

After experiencing the thrill of escaping the Nazis, life in Hungary began to lose its luster during the Soviet occupation, and I needed to seek new challenges. With my father's help, I found a way to leave Hungary. When I was 17, I became a student in London. In my studies, my main interest was to delve into understanding this strange world I was born into. But I must admit, I also harbored some fantasies of becoming a great philosopher. I believed I had gained the wisdom to distinguish myself from others.

Life in London was a great disappointment. I had no money, was alone, and no one was interested in what I had to say. But even though the wretched life forced me to make a living in a more mundane way, I did not give up my philosophical ambitions. After finishing my studies, I had a series of false starts. Eventually, I stabilized in an arbitrage trading position in New York. But in my spare time, I continued my philosophical studies.

This is how my first important article, titled "The Burden of Consciousness," came about. It was an attempt to model Popper's framework of "open and closed societies." It connected organic societies with traditional ways of thinking, linking closed societies with dogmatic ways and open societies with critical ways. The problem I could not solve properly was that I could not decompose the attributes linking ways of thinking with real social events. This problem has troubled me, and it is how I came to think of inventing the concept of "reflexivity," which I will discuss in detail shortly.

Coincidentally, the concept of reflexivity provided me with a new way to observe financial markets, a method that was better than the popular theories of the time. It gave me a basis for judgment, first as a securities analyst and then as a hedge fund manager. I felt as if I had made a significant discovery, one that could satisfy my fantasy of becoming a great philosopher. At one moment, when my business career hit a snag, I immediately turned around and devoted myself to philosophy. Because I cherished my discovery so much, I did not want to leave it for a moment. I felt that the theory of reflexivity needed to be explored more deeply. As I delved deeper into this topic, I lost myself in the maze I had constructed. One morning, I found that I could not understand what I had written the night before. At that moment, I decided to give up my philosophical exploration and focus on making money. Only many years later, after becoming a successful hedge fund manager, did I return to my philosophy.

In 1987, I published my first book, "The Alchemy of Finance." In that book, I attempted to explain the philosophical foundations of my operations in financial markets. The book attracted some attention; most people in the hedge fund industry had read it, and business schools taught it. However, the philosophical debates in the book left little impression; it was more understood as the vanity of a successful businessman who, having made money, fancied himself a philosopher.

I began to doubt whether I had made a significant discovery. After all, I was dealing with a subject that had been explored by philosophers since ancient times. What reason did I have to believe I had made a new discovery, especially when others did not think so? Undoubtedly, the conceptual framework was beneficial to me personally, but it seemed that others did not see it as having much value. I had to accept others' judgments. I did not give up my interest in philosophy, but I had come to regard it merely as a personal preference. In my business and philanthropic activities (charity had increasingly become an important part of my life), I continued to operate according to this conceptual framework, and each time I wrote a book, I would faithfully reiterate my arguments. This helped me develop my conceptual framework, but I still considered myself a failed philosopher. Once, I even gave a talk titled "A Failed Philosopher's Retry."

But all of this changed because of the 2008 financial crisis. My conceptual framework allowed me to foresee the crisis and to use it to deal with it when it finally occurred. I performed better than most people in explaining and predicting events. This changed the evaluation of my theory by myself and many others; my philosophy was no longer a personal matter; it deserved serious consideration as a potential contribution to understanding reality. This is what motivated me to give this series of lectures.

To get back to the point, today I will explain the concepts of "fallibility" and "reflexivity" as a whole. Tomorrow, I will apply them to financial markets, and later to politics. This will also introduce the concept of "open society." In the fourth lecture, I will explore the differences between market value and moral value, and in the fifth lecture, I will present some predictions and prescriptions for the current moment.

I can state the core idea in two relatively simple propositions. One is that in situations that have thinking participants, the participants' view of the world is always partial and distorted. That is the principle of fallibility. The other is that these distorted views can influence the situation to which they relate because false views lead to inappropriate actions. That is the principle of reflexivity.

For example, viewing drug addicts as criminals leads them to actually commit crimes because of a misunderstanding of the issue, interfering with appropriate treatment for addicts. Another example is that claiming the government is bad often leads to a bad government.

Fallibility and reflexivity are purely common sense. Therefore, when my critics say that I am merely stating obvious facts, they are correct, but only at the simplest level. What I find more interesting is that their significance has not been universally appreciated. In particular, the concept of reflexivity has been deliberately avoided or even denied in economic theory. Therefore, my conceptual framework deserves serious consideration, not because it is a new discovery, but because something as commonsensical as reflexivity has been deliberately overlooked.

In the field of economics, reflexivity has no place; economists always hope to find certainty, while I argue that uncertainty is a key feature of human affairs. Economic theory is built on the concept of equilibrium, but this concept directly contradicts the concept of reflexivity. As I will discuss in the next lecture, these two concepts yield two completely different explanations for financial markets.

The concept of fallibility is uncontroversial. People generally acknowledge that the complexity of the world we live in exceeds our understanding. I have not provided any greater or newer insights. The main reason is that participants themselves are part of the situation, and when processing, they often cannot process themselves. Or rather, when faced with an extremely complex reality, we have to adopt various methods to simplify (just to name a few, such as generalization, dichotomy, metaphor, decision rules, moral concepts, etc.), and when people use these methods, if they consider themselves part of the processing object, the situation becomes even more complicated.

The structure of the brain is another source of fallibility. Recent advances in brain science have provided some insights into how the brain works and have confirmed Hume's view that reason is the slave of passion. Reason comes from the fabrications of our imagination.

The brain is bombarded by millions of sensory impulses, but consciousness can only process seven or eight topics at the same time. Within limited time, these impulses must be condensed, sorted, and interpreted; errors and distortions are inevitable. Brain science adds many new details to my original argument that our understanding of the world is inherently imperfect.

The concept of reflexivity requires further explanation. It applies only to situations where thinking participants are also part of the event. Two functions form around the thoughts of participants. One is to understand the world we live in, which I call the cognitive function. The other is to change the world in a way that benefits oneself, which I call the participatory (or manipulative) function.

These two functions connect thought and reality from opposite directions. In the cognitive function, reality determines the participant's viewpoint, where the direction of causality is from reality to thought. In contrast, in the participatory function, the direction of causality is from thought to reality, meaning that the participant's intention has an impact on the world. When both functions are simultaneously at work, they can interfere with each other.

How do they interfere? By depriving each function of its independent variable, which is simultaneously the dependent variable of the other function. Because when one function's independent variable is the dependent variable of another function, neither function has a truly independent variable. This means that the cognitive function cannot produce sufficient knowledge to serve as the basis for the participant's decision-making. Similarly, the participatory function can influence the outcome of changing the world but cannot determine it independently. In other words, its outcome is likely to deviate from the participant's intention. There will inevitably be some deviation between intention and action, and further deviation between action and outcome. The thoughts of participants become an inseparable part of the situation they are trying to understand, and the development of the situation does not have independence from thought. This introduces uncertainty into both our understanding of reality and the actual development of events.

To understand the connection between uncertainty and reflexivity, we need to explore further. If the cognitive function operates in isolation and is completely unaffected by the participatory function, it can produce knowledge. This knowledge is expressed as assertions that are true if they correspond to facts, meaning that these assertions are true if they align with reality (this is the standard of judgment that truth correspondence theory tells us). However, if the participatory function interferes with the facts, thereby altering them, then the facts can no longer serve as an independent standard for judging those assertions produced by the cognitive function, because even if the assertions still correspond to the facts, the correspondence lacks independence since the facts have been altered.

Consider the assertion: "It is raining now." The truth of this assertion depends on the actual weather conditions; in fact, it is raining now. Now consider another assertion: "This is a revolutionary moment." This assertion is reflexive; its truth depends on whether the assertion itself can encourage a group of rebels to act.

Reflexive statements have a certain similarity to the liar paradox (i.e., Socrates says: Socrates is a liar). However, while self-reference has been widely analyzed, reflexivity has received much less attention. This is strange because reflexivity has an impact on the real world, while self-reference is purely a linguistic phenomenon.

In the real world, the thoughts of participants manifest not only in assertions but also in various forms of actions and habits. This makes reflexivity a very widespread phenomenon, and its usual form is feedback loops. The opinions of participants influence the development of events, and the development of events influences the opinions of participants. This influence is continuous and cyclical, thus forming a feedback loop.

Reflexivity feedback loops have not been rigorously analyzed. When I first encountered this issue and tried to analyze it, I stumbled into the complexity of the problem. I assumed that feedback loops are a two-way connection between participants' opinions and the actual processes of events. But what about the two-way connections between different participants' opinions? What if an isolated individual asks themselves "Who am I?" or "What do I stand for?" and changes their behavior in response to their own questions?

As I tried to solve these difficulties, I became increasingly lost in numerous classifications, to the point that one morning I found I could not understand what I had written the night before. It was at that moment that I decided to give up philosophy and focus on making money.

To avoid this trap, let me propose the following terms. Let us divide reality into objective and subjective aspects. Thought constitutes the subjective aspect, while events constitute the objective aspect. In other words, the subjective aspect includes what happens in the minds of participants, while the objective aspect refers to what happens in the external reality. There is only one external reality, but there are many different subjective opinions. Reflexivity can connect any two or more aspects of reality (as long as one subjective aspect is included) and establish a two-way feedback loop between them. In special cases, reflexivity can even occur within a single aspect of reality, reflected in an isolated individual's response to their own identity, which can be described as "self-reflexivity."

Then we can distinguish between two major categories: reflexive relationships (connections between subjective aspects) and reflexive events (connections that include objective aspects). Marriage is a reflexive relationship; the 2008 crisis is a reflexive event. When there is no subjective aspect involved in reality, there is no reflexivity.

Feedback loops can be negative or positive. Negative feedback brings the participants' views closer to the actual situation; positive feedback drives them further apart. In other words, a negative feedback process is self-correcting; it can continue indefinitely, and if no significant changes occur in the external reality, it may eventually reach a balance where the participants' views correspond to the actual situation. This is generally what is expected to happen in financial markets. Therefore, the concept of equilibrium, which is central to economics, is merely an extreme case of negative feedback, a limited special case within my conceptual framework.

In contrast, positive feedback is self-reinforcing; it cannot continue indefinitely because the participants' views will increasingly diverge from objective reality, ultimately forcing participants to acknowledge that their views are unrealistic. The interaction between the two will not allow the actual state of affairs to remain stable because positive feedback has the characteristic of exacerbating any existing trends in the real world, regardless of what that trend may be. Thus, we are not faced with equilibrium but rather dynamic disequilibrium, or any situation that can be described as moving further away from equilibrium. In such cases, the divergence between participants and reality will often reach a climax, triggering another self-reinforcing process in the opposite direction. This seemingly self-reinforcing process is, in fact, a self-negating boom-bust cycle, which is characteristic of financial markets but can also be found in other domains. I refer to this as a creative fallacy, meaning that people's interpretations of reality are biased, and the actions stemming from these biased views lead to real deviations that become increasingly severe.

I know all of this is very abstract and difficult to understand. If I provide some concrete examples, it will be easier to grasp. However, you will have to bear with me. If I want to present a different viewpoint, abstraction can actually help me achieve that. When dealing with topics like the relationship between reality and thought and their interconnections, people easily become confused and make erroneous simulations. Therefore, distortions and misunderstandings can play a very significant role in human affairs. The recent financial crisis may have led to erroneous interpretations of how financial markets operate. I will discuss this issue in the next lecture. In the third lecture, I will discuss two creative fallacies—the Enlightenment fallacy and the postmodern fallacy. These specific examples will focus on how misunderstandings are crucial in historical processes. But for today's lecture, I will remain at a highly abstract level.

I argue that when thinking participants engage in social phenomena, the situation has a completely different structure than natural phenomena. The difference lies in the role of thought. In natural phenomena, thought does not play a causal role; it only has a cognitive function. In human affairs, thought itself is part of the problem, possessing both cognitive and manipulative functions. These two functions (or functions) can interfere with each other. This interference does not occur all the time (it occurs in daily activities, such as driving or renovating a house, where these two functions actually complement each other), but once it occurs, it introduces uncertainties that do not exist in natural phenomena. This uncertainty manifests in both functions: participants act based on incomplete cognition, and the outcomes of their actions do not align with their expectations. This is a significant characteristic of human affairs.

In contrast, in examples of natural phenomena, the development of events does not shift based on the observer's perspective. External observers are only connected to the cognitive function, and the phenomenon itself provides a reliable standard for the observer's theory to clearly judge truth or falsehood. Therefore, external observers can gain knowledge about the natural phenomena they observe. Based on this knowledge, they can successfully manipulate nature. There exists a natural division between the cognitive function and the manipulative function. Due to this division, the two functions can easily achieve their objectives without bias in the realm of human affairs.

Here, I must emphasize that reflexivity is not the only source of uncertainty in human affairs. Yes, reflexivity indeed introduces uncertain factors into the participants' views and the actual processes of events, but other factors can produce similar effects. For example, participants may not know the information that other participants possess, leading to biases. This is quite different from reflexivity but is also a source of uncertainty in human affairs. Different participants have different interests, and some of these interests may naturally conflict with others, which is another source of uncertainty. Additionally, as Isaiah Berlin pointed out, the values followed by each participant are diverse and often contradictory. These factors create a broader uncertainty than that produced by reflexivity. I group them together to present the principle of human uncertainty, which is a broader concept than reflexivity.

The principle of human uncertainty I discuss is more specific and rigorous than the subjective skepticism that runs through Cartesian philosophy. It provides us with objective reasons to believe that the theories held by participants (as opposed to statements of specific facts) are prone to bias, incompleteness, or both.

While human uncertainty primarily affects participants, it has profound implications for social science. By invoking Karl Popper's scientific methodology, I can clearly articulate this impact. It is a beautiful, simple, and elegant theory. It consists of three elements and three actions. The three elements are scientific laws, initial conditions, and final conditions of the laws. The three actions are prediction, explanation, and verification. When scientific laws are combined with initial conditions, predictions can be made. When they are combined with final conditions, explanations can be provided. In this sense, prediction and explanation are symmetrical and reversible. Verification, on the other hand, is responsible for comparing predictions derived from scientific laws with actual results.

According to Popper, scientific laws are essentially hypothetical; they cannot be confirmed but can be falsified through verification. The key to the success of scientific methodology is that it can utilize the participation of individuals to collectively verify a theory, and all individual participation becomes part of the verification. A single individual's failed verification is sufficient to falsify a theory, but no amount of confirming instances can fully confirm it.

How can science be both empirical and rational? For this tricky question, Popper provides a clever approach. According to Popper, it is empirical because we test our theories by observing whether the predictions derived from them align with reality; it is rational because we use deductive logic to arrive at those predictions. Popper rejected inductive logic, instead emphasizing verification. Induction is unfalsifiable and thus unscientific. Popper highlighted the central role of verification in scientific methodology and strongly argued that scientific laws are only temporarily valid and always open to re-examination. Therefore, the three notable characteristics of Popper's theory are the symmetry between prediction and explanation, the asymmetry between verification and falsification, and the central role of verification. Verification allows science to develop, improve, and innovate.

Popper's theory works well for studying natural phenomena, but the principle of human uncertainty injects discord into this extreme simplicity and elegance. Because uncertainty is introduced into predictions, the symmetry between prediction and explanation is disrupted, and the central role of verification is put at risk. Whether to include participants' thoughts in the initial and final conditions is a very important question because every verification requires replicating those conditions. If participants' thoughts are included, it becomes difficult to observe the initial and final conditions because participants' views can only be inferred from their statements or actions. If they are excluded, the initial and final conditions do not constitute a single observation target, as the same objective conditions may be associated with vastly different subjective views due to the participants' differences. In either case, induction cannot be properly verified. This difficulty does not prevent social scientists from obtaining valuable conclusions through induction, but these conclusions do not meet the requirements of Popper's theory and do not align with the predictive capabilities of physical laws.

Social scientists find this conclusion difficult to accept. Economists, borrowing from Freud, are experiencing "physics envy."

To eliminate the aforementioned difficulties associated with the principle of human uncertainty, many attempts have been made to introduce or assume some fixed relationships between participants' thoughts and reality. Karl Marx asserted that the material conditions of production determine the ideological superstructure. Freud believed that human behavior is determined by a combination of impulses and the subconscious. They both claimed their theories were scientific, but Popper pointed out that they could not be falsified, thus they are pseudoscientific.

However, to date, the most impressive attempts have been made in the field of economic theory. It began with the assumption of perfect knowledge, and when this assumption was proven untenable, it was maintained by continually increasing distortions to uphold the myth of rational behavior. Economics culminated in the rational expectations theory, which posits that if there is an optimistic expectation about the future, as a response to this expectation, ultimately all market participants will converge towards it. This assumption is absurd, but it was necessary for modeling economic theory on the basis of Newtonian physics.

Interestingly, when they communicated in the journal "Economics," both Popper and Hayek found that social science could not produce results comparable to those of physics. Hayek vehemently criticized the mechanical and uncritical application of quantitative methods from natural sciences to economics, calling it scientism. Karl Popper, in "The Poverty of Historicism," pointed out that history is not determined by universally valid scientific decisions.

Nevertheless, when Popper proclaimed his so-called "methodological unification" theory, he meant that natural and social sciences should use the same methods. Hayek, of course, became an apostle of the Chicago School of Economics, which is the stronghold of market fundamentalism. But in my view, the implication of the principle of human uncertainty is that the subjects of natural and social sciences are fundamentally different; therefore, they require different methods and standards. One cannot expect economic theory to produce universally valid laws that can be used to reverse-engineer or predict historical events. I argue that merely mimicking natural sciences will lead to distortions in human and social phenomena. What works in physics fails in sociology.

However, due to an overemphasis on the differences between natural and social sciences, I have also encountered some difficulties. This dichotomy is often not found in reality; rather, we introduce it to make this confusing reality easier to understand. In fact, even though a strict distinction between physics and social sciences seems reasonable, there are always other disciplines, such as biology and animal social studies, that occupy an intermediate position and cannot be strictly distinguished.

But I must set aside my reservations and first acknowledge that a division between natural and social sciences is necessary. Because social sciences encounter another difficulty that natural sciences can avoid.

This difficulty is that social sciences are reflexive. The uncertainty principle discovered by Heisenberg does not change quantum behavior at all, but social theories, whether Marxist, market fundamentalist, or reflexivity theory, can influence the social domains they address. The scientific method is considered to rely on truth. Heisenberg's uncertainty principle does not contradict this assumption, but reflexive social theories do. Why can social sciences actively change society but are limited to passively studying social phenomena? As I said in "The Alchemy of Finance," alchemists made a mistake by trying to change the nature of base metals through spells. Instead, they should focus on participating in financial markets, where they might succeed.

How can social sciences exclude such interference? I propose a simple remedy: acknowledge the dichotomy between natural and social sciences. This will ensure that people can correctly appreciate the merits of social theories without mistakenly diagnosing them using methods from natural sciences. I suggest using this as a research framework to protect scientific methods, which does not imply devaluation of social sciences. This framework does not limit what social sciences can study; rather, by liberating social sciences from blind imitation of natural sciences, it can prevent them from being swayed by erroneous standards and potentially open up new horizons.

Reflexivity Theory Application#

Why Reflexivity Theory?

Our interest in Soros is not merely because the Quantum Fund made $5.5 billion last year, but because he bridged the gap between macro and investment, being a pioneer of hedge funds that emerged in the 1970s, and has led to widespread monetary shocks. More importantly, the critiques of economics come from various angles, and Soros's critique is one of the most powerful. Understanding Soros's investment philosophy, reflexivity theory challenges the notions of "rationality" and "equilibrium" in economics, pointing out the existence of non-equilibrium states that deviate from the classical notion of "equilibrium."

Due to the non-objectivity of historical processes involving thinking participants, the scientific nature of economics is difficult to establish. Therefore, economics cannot use the same methods to produce results comparable to those of physics; however, it does not limit the achievements that social sciences can achieve using different methods. The erroneous theories that led to the formation of the "super bubble," the policy mistakes that emerged after the crisis, and the mishandling of the ongoing euro crisis all highlight the human suffering that can arise from a fundamental misunderstanding of the nature of the economic system. Recognizing our fallibility will greatly enhance our understanding. Explaining economics as a reflexive system may not prevent future bubbles, crises, or policy mistakes, but it could lead to a deeper understanding of economic and socio-political phenomena and help humanity better manage future affairs.

I recognize that my approach is still in its early stages. I have developed it mostly in my inner world throughout my life. It has only been in recent years that I have benefited from substantial criticism. Whether my conceptual framework can develop into a new paradigm remains to be seen. This largely depends on whether reflexive feedback loops can be accurately modeled. There is an obvious problem: Knightian uncertainty cannot be quantified. However, trends can be identified without quantifying them, and changes in trends can be recognized without specifying when they will occur. This is what I have done in the boom-bust model. We can also use quantifiable volatility as a substitute for uncertainty. There may be other techniques that can address these issues, such as the economics of incomplete knowledge (Frydman & Goldberg, 2013) or new methods yet to be invented.

A new paradigm must be fundamentally different from the failed paradigm. It cannot be static; it must recognize that some changes are non-repetitive while others exhibit statistical regularity. Furthermore, economic theory cannot isolate itself from other disciplines and reality. It cannot be limited to studying the allocation of limited means among infinite alternative objectives; it must consider the impact this allocation may have on prevailing values and production methods.

Clearly, I cannot develop my ideas alone. This is why I am pleased that the Economic Methodology Journal has published this special issue.