The Alchemy of Finance: Reading the Mind of the Market (Hardcover)

by George Soros

By Christopher Hefele (Lawrenceville, NJ United States) 

Soros is unquestionably one of the finest investors of our time, and the concept of "reflexivity" that he introduces in this book does have some merit. However, I found his wordy tome is a slightly burdensome read. Most of his most valuable points are in the first 80 pages; the remaining 300 could have been trimmed down by a wise editor.

Soros' main points revolve around a concept that he dubs "reflexivity." Reflexivity claims a few things: First, that prices aren't objective; they're based on people's biased perceptions of the fundamental factors influencing the market. Second, people make trades based on their biased perceptions, so perceptions will influence the market. Third, and most importantly, those market movements can in turn change the market's underlying fundamentals. There is, therefore, a continuous co-evolution of the market fundamentals, the market's price movements, and market participants' perceptions.

Let's run through an example to make this clear. Say a profitless Internet company's stock soars because investors have overblown expectations of earnings growth. That company could then use its inflated stock in a stock-swap to aquire another company that DOES has earnings. This aquisition would thus "justify" the stock's inflated stock value. Thus, mistaken perceptions have allowed a change in the structure of an industry (i.e. two companies merged which would not have earlier).

Soros makes a number of other valuable points about "reflexivity." He notes that traditional economics try to sidestep the issue of subjectivity and biased perceptions by assuming people behave rationally, which of course isn't always true. To demonstrate this, he points out that we see reflexive behavior all over the markets. For example, we see self-reinforcing price trends (people buy because a stock is going up, or sell when it's going down), rather than random-walks in prices. We see booms & busts in the credit markets. And so on.

Finally, the genesis of the title, "The Alchemy of Finance" comes from Soros' observation that finance can never be a science because the traditional tools of science -- that is, explanation, prediction and objectivity -- can't be used, because perceptions and subjectivity cannot be seperated out like they can in a controlled science experiment. Finance can only be a form of alchemy -- it seeks operational success, instead of being able to seeking and test fundamental laws as the scientific method does.

Overall, I found the book insightful in parts, but rambling. Some other reviewers claimed that the book was pseudo-intellectual. I did find that it lack academic rigor, but I can't be sure if that's because he was writing for a popular audience.

Since the book was written in the late 80's, there's been growing interest & academic research at the intersection between psychology and financial markets. Soros was not the first to recognize that financial markets involve a good dose of psychology, but his book serves to underscore this important truth about the market.