A few days ago, I watch watching television late at night and was about to go to bed when I noticed the next show was a documentary called "Soros," a film by Jesse Dylan. I checked if it was on any of the streaming services I have, and it was not so I decided I better stay up and watch this 90-minute program on George Soros (Trades, Portfolio), more out of respect for the man than anything else. It was late and I knew I was going to be sleepy.
I did not fall asleep, though, as Soros is a fascinating person. If you are interested in the investor's personal history and public activism, then the film is worth watching, but there iss very little on finance. Even his theory of reflexivity was covered only in passing. GuruFocus readers only interested in the investment guru side of Soros can safely give this documentary a pass.
I have read most the books Soros has written, and one of his biographies (which I reviewed here). The best two are "Soros on Soros" with Byron Wien and Krisztina Koenen, and his first book "The Alchemy of Finance," which this review is about.
While "Soros on Soros" influenced John Paulson (Trades, Portfolio) to be aggressive in his big subprime bets, the legend that is Paul Tudor Jones (Trades, Portfolio) says in Alchemy’s forward that it one of two books that are a timeless instructional guide of the marketplace, alongside "Reminiscences of a Stock Operator."
I think "The Alchemy of Finance"is Soros’ best and most important book largely becauseof the unique real-time experiment that takes up five chapters in part three, which covers Soros’ portfolio management in 1985 and 1986. I will revisit this topic later.
It is important to note that the book is not an easy read. Although it is not well written, that is not a criticism as it reflects Soros’ deep and complicated thinking. Managing a leveraged hedge fund is complicated and, unlike Warren Buffett (Trades, Portfolio), Soros does not have a clear process of investing. Rather, he has a philosophy and a flexible theory, which he calls reflexivity.
I first read "The Alchemy of Finance" when I was 17 or 18. Needless to say, I did not understand anything. Only after an undergraduate degree in finance and a better knowledge of economics could I start to make sense of the book. I would have been better off studying philosophy, though, as the investor criticizes academic, financial and economic theory. Rather, he credits philosopher Karl Popper for greatly influencing his thinking.
Soros says that social scientists are envious of natural scientists’ mathematical modelling and proofs, and have, therefore, built up a framework of rational expectations that models well, but in reality is totally useless. Indeed, Soros argues that Werner Heisenberg’s uncertainty principle recognizes that we cannot know both the position and speed of a particle, such as a photon or electron, with perfect accuracy, but natural sciences has still have produced amazing results. Human sciences ignore uncertainty because everyone is rational. The problem, Soros shows, is that in real life, there is a circular relationship between cause and effect. Things which on paper should be ridiculous can become a self-fulfilling prophecy.
Part one
Chapter one describes reflexivity in the stock market. A good example is that people believe stock markets anticipate recessions. Soros says it would be more correct to say that stock markets can help to precipitate them. Instead of thinking that markets are always right, it would be better to think:
- Markets are always biased in one direction or another.
- Markets can influence the events that they anticipate.
He wrote, "The trend in stock prices can then be envisioned as a composite of the 'underlying trend' and the 'prevailing bias.'"
Soros then provides a case study on when he wrote and widely distributed a research report on real estate investment trusts. In today’s language, we might say the report went viral and helped influence the boom-bust sequence in that sector. The best activist investors today understand this. They set out to change the prevailing bias in the narrative on a company through convincing the management and the market there is a better alternative. When they win the argument through a sensible financial strategy coupled with strong public relations, this can be very powerful in the short term.
Chapter two describes reflexivity in the currency market very well. Economists would have you believe that currencies simply reflect underlying economic conditions. Soros, however, says that currencies can influence economic conditions, which in turn influence currencies, and this becomes a circular loop, with the trend reinforcing itself until it becomes totally unsustainable. Soros does not believe in equilibrium; his idea of markets is all about the boom-bust sequences.
Part two
The second section of the book is a historical perspective of the macroeconomic environment following the breakdown of Bretton Woods in the early 1970s. While Soros calls himself a speculator, his edge was having a deep understanding of what was going on, economically and politically, and how policy making and international fund flows would interact. The chapter titled "Reagan’s Imperial Circle" covers an interesting framework using the economy, currency, budget deficits and trade deficits. The “model” does not seem to be completely internally consistent as it is flexible and, ultimately, “hot money” becomes an important driver.
Part three: The real-time experiment
The third part of the book is a real-time diary of Soros’ thinking, trades and decision-making. It is clear that being a macro fund manager was a 24/7 job for the investor as he lived and breathed it.
The instruments he traded at this time were mostly currencies, commodities, bonds and stock indexes. He thought about how individual positions fit inside the portfolio, and when he had high conviction, he would be at maximum risk. When he had low conviction, he would have smaller risk. Then he would cut the holding if he was wrong and add when he was right. Soros says the process of writing the diary helped him think through more clearly what was happening and how he should position himself, but most of the diary is simply thinking out scenarios and then explaining how he had reacted to events.
It is also clear that Soros' global macro style is quite multidimensional. However, the process of writing down possible scenarios and how we made decisions in our own portfolios can be helpful for us to identify and correct mistakes for the future.
Conclusion
Ultimately, the book is quite advanced, very conceptual and, at times, difficult to follow, yet it is a really important book I would recommend that people interested in global macro read. Reflexivity is an important concept to think about how markets work. Telsa (TSLA) would be a good recent example as the story and the hype fed on itself until finally the Federal Reserve started raising interest rates, which pricked the bubble.
Knowing a few different areas deeply, but being humble enough to realize we can never really know the future, being brave to bet big on trends we think have started and not getting emotionally attached to positions is another good lesson we can take away from this book. Unlike Buffett, Soros had a pretty short investment horizon most of the time, but he managed risk very well. He developed investment hypothesises and bet big and cut losses quickly. In a complicated world with so many moving parts, we can learn a lot from Soros’s writing of more than 35 years ago.
