The Alchemy of Finance by George Soros

George Soros is one of the world's richest men. He had a net worth of $8.3Billion As of May 2020. Primarily, he's been accumulating this fortune through investing, and more specifically, through his hedge funds Quantum Fund and Soros Fund Management. If you also consider that this man has donated about $32 billion to philanthropy, you can say that, well, his investing career has been quite successful. George Soros's investment strategy is much different from that of many of the other legendary investors that I've covered on this post before, in that, he doesn't really have a specific set of rules that he adheres to There's something else ... Something quite ingenious ... Something that you will learn in just a little bit, which has made him this filthy rich.

This is Healthy Mind - Think Big, bringing you the best tips and tools for reaching your financial freedom goals And this is a Top 5 Takeaway Summary of The Alchemy of Finance, written by George Soros. 

The fifth most important takeaway from the book, in my opinion, is the ability to be able to distinguish between natural science and social science Imagine that you are a scientist who is supposed to predict how fast a certain balloon will rise to the sky. 

You know all the facts: the volume of the balloon, which gas it's filled with, its aerodynamics, the exact wind of that day, etc With these facts at your disposal, and well, if you have a master's degree in physics and a Ph.D. in aerodynamics, you will be able to predict exactly how fast this balloon will rise to the sky. This is a natural science. Now imagine that you are a hedge fund manager who is supposed to predict how fast the S&P500 will rise in the coming year. You know all the facts: the growth of GDP, interest rates, the global trade situation, unemployment rates, etc. Even with these facts at your disposal, and yes, even if you have a master's degree in economics and a Ph.D. in finance, you won't have a chance of predicting how fast the S&P500 will rise in the coming year. This is a social science, What's the difference? It's the existence of a thinking participant In natural science, facts lead to new facts. The facts about the balloon and its surroundings can help us in predicting the fact about how fast the balloon will rise In social science, however, facts are perceived in a certain way by the thinking participants, which only then leads to new facts. It's like being a scientist who is given the task of predicting how fast a balloon will rise, with a slight twist: The balloon doesn't really know if it wants to act like it's filled with helium or with oxygen! Assuming that natural science and social science operate under the same premises is, first, more common than you may think, and secondly, can lead to great consequences, if your goal is to achieve high market returns, which we shall see next.

Number 04: Using a faulty model is more dangerous than using no model at all. Economy and finance are the main subjects of social science that George Soros is concerned with in The Alchemy of Finance, and luckily, they are the only fields which we care about at this Blog as well. To cope with the problem that was presented before - that the participants in social science think, which in turn influences the events they participate in - economists have introduced some assumptions to their models. Reality is not as straight forward as Force = Mass * Acceleration in the financial world, but that doesn't stop the economists from simplifying to make it look so, Nah-ah! If a triangle doesn't add up to 180 degrees, the mathematician would complain, but the economists probably wouldn't care too much. This is not just stupid, it is also very dangerous.

Case in point: the financial crisis Many credit institutes and insurance companies acted on the false assumption that mortgages were uncorrelated. They did not expect that a collapse in the housing market, caused by these thinking participants, would have mortgages default in droves. Their models did not allow for it. This intensified the following market crash, as it had fooled many investors to accept too much risk Okay, so what're the implications for us who are trying to steer the financial markets? It's that we must satisfy ourselves with conclusions that are much less definite than economists have previously sought to provide using a faulty model is much more dangerous than using no model at all And as we shall see in the final takeaway, betting against those who rely too heavily on models can prove to be a very profitable strategy for an investor. 

Number 03: Reflexivity Actually, reflexivity should probably be on top of this list, because it's George Soros' most important contribution to the understanding of economics and finance But well, it wouldn't make much sense presenting the rest of the takeaways in this post without it, so here it goes. The worldview of the thinking participants will inevitably deviate from what is actually going on Also, their imperfect understanding affects that same world. This causes feedback loops "The participants' views influence the course of events, and the course of events influences the participants' views." This is reflexivity - and it has no counterpart in natural science.

The stock market is a perfect example: A favorable view of the market makes it easy for companies to attract capital, both from investors and from borrowers. When companies can more easily attract capital, investors' view of the market improves.

Another great example is the economy and regulators If regulators, being the thinking participants, have a favorable view of the economy, countercyclical interventions such as increased taxes or reduce public expenditures could be expected. When this happens, companies act differently, which in turn affects how regulators view the current situation and maybe you don't need a third example, but I like this one too much to skip it What we are and what we think of ourselves is a reflexive process as well If you view yourself as a person with confidence, for example, you act like you have more confidence, and people around you will notice and behave like you're an authority This reinforces your belief that you are a confident person. If you are into maths you may think about this as two functions: The cognitive function - which is how we try to understand the world we live in; and: The participating function - which is how we try to manipulate that situation to our advantage As both functions operate at the same time, they interfere with each other, and as stated earlier, it typically creates feedback loops These feedback loops can be self-reinforcing, which causes many of the most commonly used models in economics to fall short.

Number 02: The boom-bust model. One of the most elementary models in economic theory is that of supply and demand. Those who produce or own something, are willing to produce or sell more of this as prices rise. Those who are interested in buying the same thing, are willing to buy less of this as prices rise. The intersection of these two curves is said to be the price where sellers (or supply) and buyers (or demand) meet. This is supposed to be at equilibrium, if fundamentals change to make buyers more interested, the equilibrium moves upwards and prices move higher, and vice-versa You don't really need to know the details about this, but the important thing to remember here is that conventional wisdom says that prices always move towards an equilibrium.

George Soros does not believe in this Instead, he suggests that prices move in a boom-bust fashion. The stock market will work as a great illustration of his "boom-bust model". 

First, there's a self-reinforcing trend based on changes in fundamentals or facts, if you will because of reflexivity, a positive feedback loop is created which set things in motion because the motion is self-reinforcing, it doesn't stop at some "equilibrium". The trend could be upward or downward, it doesn't matter.

Secondly, the investing community will realize that the market has moved too far away from what the fundamentals in the economy should allow for Thirdly, this causes the opinion of investors to change, and the market will self-correct. Given some time, reflexivity will cause positive feedback loops that are self-reinforcing, but this time, in the opposite direction. The force is too strong to stop at any equilibrium that fundamentals would suggest. The market has now gone through both a boom and a bust So... Prices in the stock market do not move towards equilibrium, but rather, they move away from it until it becomes obvious from fundamental factors that the boom or bust has gone too far Then, the direction changes.

In my summary of Howard Marks' book "Mastering the Market Cycle", you can learn to identify when we are close to one of these booms or busts, to be able to profit from market swings.

Check out that post after this one... Number 01: The stock market is a laboratory for testing hypotheses. George Soros views his investing approach as alchemy rather than science. In alchemy, one seeks to "bring about a desired state of affairs", while in science, one seeks to "find the greater truth". Alchemy can be achieved without science, Soros is very clear on this point. He does not suggest that he can forecast any events, but he has proven that he can profit from them nonetheless. He is constantly posting new hypotheses to the market and sees it as a laboratory for testing these In science, hypotheses are either proven or rejected, but in investing, they lead to operational success or failure.

I think the most interesting thing about George Soros' investment philosophy is that he doesn't obey a specific set of rules. He believes that the market is always changing, and therefore, no set of rules can make an investor outperform the market over any longer time periods Instead, George Soros is profiting from when the underlying rules are changing. When other investors have come to believe in their carved in stone models a bit too much, Soros is there to profit from their mistakes. George Soros is one of the greatest investors of all time, but his advice in The Alchemy of Finance is a bit too abstract for my taste. If you want to learn more practical advice on how to profit from swings in the markets, head over to my summary of Howard Marks' book "Mastering the Market Cycle" Cheers guys!