Lessons From A Trading Great: George Soros

Remember the scene from the 90’s classic, The Sandlot, where “Smalls” loses his father’s Babe Ruth autographed baseball to “The Beast” and the other kids question him in disbelief, saying:

Smalls: I was gonna put the ball back.

Squints: But it was signed by Babe Ruth!

Smalls: Yeah, you keep telling me that! Who is she?

Ham Porter: WHAT? WHAT?

Kenny: The sultan of swat!

Bertram: The king of crash!

Timmy: The colossus of clout!

Tommy: The colossus of clout!

All: BABE RUTH!

Ham Porter: THE GREAT BAMBINO!

Smalls: Oh my god! You mean that's the same guy?

All: YES!

Benny Rodriguez: Smalls, Babe Ruth is the greatest baseball player that ever lived. People say he was less than a god but more than a man. You know, like Hercules or something. That ball you just aced to The Beast is worth, well, more than your whole life.

Smalls: [Falls to the ground and clutches his stomach, groaning] I don't feel so good.

All: [Fanning Scott with their caps] Give him air, give him air.

If there’s a trader equivalent to baseball’s greatest; a sultan of swat, a colossus of clout, or a king of crash, then it’s undoubtedly George Soros, the GREAT BAMBINO of markets.

Soros founded and ran the legendary Quantum Fund which compounded at 32%+ between 1969 and 2000 (over 30 years). A $1000 investment in the Quantum Fund at inception would have been worth over $4 million by 2000. This makes Soros arguably one of the most successful hedge fund managers of all time. He also worked with and mentored other trading greats such as Stanley Druckenmiller and Jim Rogers.

The man is known for single handedly taking down the Bank of England, in a 1992 bet against the pound, that netted over $1 billion in the course of a single day. He seemed to play the markets on a whole other level than his peers. There are stories of him correctly flipping huge positions because of a “back ache” that made him sense trouble.

Soros retired in 2011 from managing outside money so he could focus on trading his own vast fortune, estimated to be over $25 billion. Even in his 80’s, he continues to kill it as well as train some of the best managers who go on to start their own successful hedge funds.

Needless to say, the Sultan of Swat knows a thing or two about markets. Here’s some of his words of wisdom:

Trading, Bubbles and Markets

It's not whether you're right or wrong that's important, but how much money you make when you're right, and how much you lose when you're wrong.

My approach works not by making valid predictions, but by allowing me to correct false ones. Typically bubbles have an asymmetric shape. The boom is long and slow to start. It accelerates gradually until it flattens out again during the twilight period. The bust is short and steep because it involves the forced liquidation of unsound positions. Disillusionment turns into panic, reaching its climax in a financial crisis.

Every bubble has two components: an underlying trend that prevails in reality and a misconception relating to that trend. When a positive feedback develops between the trend and the misconception, a boom-bust process is set in motion. The process is liable to be tested by negative feedback along the way, and if it is strong enough to survive these tests, both the trend and the misconception will be reinforced.

When the California residential home market collapsed, the market thought the company might go broke, but it survived the test and we made a fortune. That is when I made the rule that one should own stocks when they have successfully passed a difficult test, but one should avoid them during the test — something that is easier said than done.

A positive feedback is self-reinforcing. It cannot go on forever because eventually, market prices would become so far removed from reality that market participants would have to recognize them as unrealistic. When that tipping point is reached, the process becomes self-reinforcing in the opposite direction.

Usually some error in the act of valuation is involved. The most common error is a failure to recognize that a so-called fundamental value is not really independent of the act of valuation. That was the case in the conglomerate boom, where per-share earnings growth could be manufactured by acquisitions, and also in the international lending boom where the lending activities of the banks helped improve the debt ratios that banks used to guide them in their lending activity.

I look for conditions of disequilibrium. They send out certain signals that activate me. So my decisions are really made using a combination of theory and instinct. If you like, you may call it intuition.

I watch out for telltale signs that a trend may be exhausted. Then I disengage from the herd and look for a different investment thesis. Or, if I think the trend has been carried to excess, I may probe going against it.

I am particularly keen on investment theses that the market is reluctant to accept. These are usually the strongest.

It goes to show that when you are confused it is best to do nothing. You are just going for a random walk and that is when you are liable to get mugged because you don't have staying power. You are likely to be faked out by some stray fluctuation because you lack the courage of your convictions.

At any moment of time there are myriads of feedback loops at work, some of which are positive, others negative. They interact with each other, producing the irregular price patterns that prevail most of the time; but on the rare occasions that bubbles develop to their full potential they tend to overshadow all other influences.

My interpretation of financial markets differs from the prevailing paradigm in many ways. I emphasize the role of misunderstandings and misconceptions in shaping the course of history. And I treat bubbles as largely unpredictable. The direction and its eventual reversal are predictable; the magnitude and direction of the various phases is not.

Markets tend to move in fits and starts, adopting a thesis and then abandoning it. We try to catch them if we can, but if we can't, we are better off not trying.

I was prepared for a regime change, whereas other people were acting within a prevailing regime. And that is where I think my awareness that conditions can undergo revolutionary change was useful.

Most of the time we are punished if we go against the trend. Only at inflection points are we rewarded.

The whole thrust of my approach is that the course of events is indeterminate.

Being so critical, I am often considered a contrarian. But I am very cautious about going against the herd; I am liable to be trampled on... Most of the time I am a trend follower, but all the time I am aware that I am a member of the herd and I am on the lookout for inflection points.

The market is a mathematical hypothesis. The best solutions to it are the elegant and the Simple.

When you're sure you are right, no trade is too big.

On His Theory of Reflexivity

Reflexivity sets up a feedback loop between market valuations and the so-called fundamentals which are being valued. The feedback can be either positive or negative. As a student of economics, I found it strange that classical economic theory, particularly the theory of perfect competition, should assume perfect knowledge. I was also rather weak in mathematics, so I preferred to question the assumptions rather than to study the equations based on them. I cogitated and concluded that economics theory is based on false premises. That is how I developed my theory of reflexivity, which recognizes a two way interaction between thinking and reality.

The reflexive nature of human relations is so obvious that the question I would like to ask is, why has reflexivity not been properly recognized? Why, for instance, did economic theory deliberately ignore it? [And the answer is because] it cannot be reconciled with the goals of analytical science, which is to provide determinate predictions and explanations. Reflexivity throws a monkey-wrench into the works by introducing an element of uncertainty.

Volatility is greatest at turning points, and diminishes as a [new] trend is established. Bubbles are not the only manifestations of reflexivity, but they are the most spectacular.

I propose that we need three categories — true, false, and reflexive. The truth value of reflexive statements is indeterminate. It is possible to find other statements with an indeterminate truth value, but we can live without them. We cannot live without reflexive statements. I hardly need to emphasize the profound significance of this proposition. Nothing is more fundamental to our thinking than our concept of truth.

If a self-reinforcing process goes on long enough it must eventually become unsustainable because either the gap between thinking and reality becomes too wide or the participant's bias becomes too pronounced. Hence, reflexive processes that become historically significant tend to follow an initially self-reinforcing, but eventually self defeating, pattern. That is what I call the boom/bust sequence.

Economics theory tried to imitate physics. Classical economists took Newton as their model — forgetting that Newton lost a fortune in the South Sea Bubble. The only way they could imitate physics was by eliminating reflexivity from their subject. Hence the assumption of perfect knowledge, which was later amended to perfect information.

Regarding Philosophy and Knowledge

What is imperfect can be improved. Accepting the uncertainties connected with our fallibility opens up the vista for infinite improvement.

I used to do a lot of philosophical speculation as a young man. I wasted a large part of my youth regurgitating certain ideas. Then I discovered that one can learn a great deal more through action than through contemplation. So I became an active thinker where my thinking played an important role in deciding what actions to take and my actions play an important role in improving my thinking. This two-way interaction between thinking and action became the hallmark of my philosophy and the hallmark of my life.

I content that taking fallibility as the starting point makes my conceptual framework more realistic. But at a price: the idea that laws or models of universal validity can predict the future must be abandoned.

Financial markets, far from accurately reflecting all the available knowledge, always provide a distorted view of reality. This is the principle of fallibility. The degree of distortion may vary from time to time. Sometimes it's quite insignificant, at other times it is quite Pronounced.

Economic theory needs to be fundamentally reconsidered. There is an element of uncertainty in economic processes that has been largely left unaccounted for... We must take a radically different view of the role that thinking plays in shaping events.

If we accept that our understanding is inherently imperfect, we can build a value system on that insight. That is what I have done with my belief in my own fallibility.

It seems that we need to recognize more than two categories — true and false. The logical positivists claimed that statements which are not true or false are meaningless. I thoroughly disagree. Theories that can affect the subject matter to which they refer are the opposite of meaningless. They can change the world. They exemplify the active role that thinking can play in shaping reality. We need to adjust our concept of truth to account for them.

On Risk Taking, Forming Hypothesis and Being Wrong

I work with hypotheses. I form a thesis about the anticipated sequence of events and then I compare the actual course of events with my thesis; that gives me a criterion by which I can evaluate my hypothesis.

The prevailing wisdom is that markets are always right. I take the opposite position. I assume that markets are always wrong. Even if my assumption is occasionally wrong, I use it as a working hypothesis.

Risk taking is painful. Either you are willing to bear the pain yourself or you try to pass it on to others. Anyone who is in a risk taking business but cannot face the consequences is no good.

There is nothing like danger to focus the mind, and I do need the excitement connected with taking risks in order to think clearly. It is an essential part of my thinking ability. Risk taking is, to me, an essential ingredient in thinking clearly.

As an investor, I find statistical probability of limited value; what matters is what happens in a particular case. The same applies with even greater force to historic events. I cannot make reliable predictions about them; all I can do is formulate scenarios. I can then compare the actual course of events with the hypothetical ones. Such hypotheses have no scientific validity, but they have considerable practical utility. They provide a basis for real-life decisions.

The generally accepted theory is that the financial markets tend toward equilibrium and, on the whole, discount the future correctly. I operate using a different theory, according to which financial markets cannot possibly discount the future correctly because they do not merely discount the future; they help to shape it.

To others, being wrong is a source of shame; to me, recognizing my mistakes is a source of pride. Once we realize that imperfect understanding is the human condition, there is no shame in being wrong, only in failing to correct our mistakes.

I am outside. I am a thinking participant and thinking means putting yourself outside the subject you think about. Perhaps it comes easier to me than to many others because I have a very abstract mind and I actually enjoy looking at things, including myself, from the Outside.

[The danger in taking risks] stimulates me. But don't misunderstand what I am saying: I don't like danger; I like to avoid it. That is what makes my juices flow. I am good at riding the tide, but not the ripples of a swimming pool.

I would put it this way: I do not play according to a given set of rules; I look for changes in the rules of the game.

I'm only rich because I know when I'm wrong... I basically have survived by recognizing my mistakes.

Economic Theory

Economic history is a never-ending series of episodes based on falsehoods and lies, not truths. It represents the path to big money. The object is to recognize the trend whose premise is false, ride that trend, and step off before it is discredited.

I am not knocking economics; I think it is a very elegant theoretical construct. I do question its applicability to the real world; and I question whether it survives testing in the financial markets. I believe that the performance of Quantum Fund alone falsifies the random walk theory.

There are two kinds of disequilibrium: static disequilibrium, where both the prevailing dogma and the prevailing social conditions are rigidly fixed but quite far removed from each other; and dynamic disequilibrium, where both the real world and the participant's views are changing so rapidly that they cannot help but be far apart.

Economics is a social science and there is a fundamental difference between the natural and social sciences. Social phenomena have thinking participants who base their decisions on imperfect knowledge. That is what economic theory has tried to ignore.

If you consider our position as human beings trying to understand the world in which we live, you will find that we cannot confine our thinking to subjects that are independent of our thinking. We must make decisions about our lives and in order to do so we must hold views that do not qualify as knowledge, whether we recognize this or not. We must have recourse to beliefs. That is the human condition.

Natural science deals with events that occur independently of what anybody thinks about them; therefore, it can treat events as a succession of facts. When events have thinking participants, the chain of causation does not lead directly from one set of facts to the next; insofar as the participant's thinking plays a role, it leads from facts to perceptions, from perceptions to decisions and from decisions to the next set of facts. There is also the direct link between one set of facts and the next which is characteristic of all natural phenomena. But the more circuitous link cannot be left out of account without introducing a distortion. The distortion is negligible when people's thinking is close to reality: it becomes significant when perception and reality are far apart.

The market mechanism is better than other arrangements only because it provides feedback and allows mistakes to be corrected. This is the equivalent of Churchill's dictum about democracy: It is the worst system, except all the others.

Ever since the Crash of 2008 there has been a widespread recognition, both among economists and the general public, that economic theory has failed. But there is no similar consensus... on the nature and implications of that failure... I believe that the failure is more profound than generally recognized. It goes back to the foundations of economic Theory.

Economics tried to model itself on Newtonian physics. It sought to establish universally and timelessly valid laws that govern reality. But economics is a social science and there is a fundamental difference between the natural and social sciences. Social phenomena have thinking participants who base their decisions on imperfect knowledge. That is what economic theory has tried to ignore.

Classical economic theory assumes that market participants act on the basis of perfect knowledge. That assumption is false. The participant's perceptions influence the market in which they participate, but the market action also influences the participant's perceptions. They cannot obtain perfect knowledge of the market because their thinking is always affecting the market and the market is affecting their thinking.

When speculators profit, the authorities have failed in some way or another. But they don't like to admit failure; they would rather call for speculators to be hung from lampposts than to engage in a little bit of soul-searching to see what they did wrong.

I am not well qualified to criticize the theory of rational expectations and the efficient market hypothesis because as a market participant I considered them so unrealistic that I never bothered to study them.

When Soros was at the height of his game he was so in tune with markets that he seemed to effortlessly pull out profits as he managed his capital like a well honed conductor. During this time he said “I stood back and looked at myself with awe: I saw a perfectly honed machine.” A “perfectly honed machine” indeed. Study and practice these tips and work on honing your machine.

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