Discount the obvious, bet on the unexpected

Aug 28, 2018

Let me start with an interesting anecdote narrated by Stanley Druckenmiller in The New Market Wizards: Conversations with America’s Top Traders.

At one time during his trading career, Stanley was very bearish on the dollar and took a short position of $1 billion against the Deutsche mark. To his good fortune, the trade started moving in his favour. His boss comes into his office for a chat and they discuss the deal. When Stanley says that he took a $1 billion bet, the boss scoffs and states, “you call that a position?” His suggestion – double it. Stanley did. The trade went dramatically in his favour.

That boss was George Soros, who Stanley describes as the best loss taker he has ever seen.

He is most famous for his 1992 bet when he shorted the British pound. On September 16 that year, he made close to $2 billion ($1 billion from the pound, $1 billion out of the chaos of the Italian and Swedish currencies and in the Tokyo Stock Exchange). The Financial Times dubbed him as the man who broke the pound.

His sensational appetite for risk has made him one of the richest men in the world. It also gave him a fair share of knocks. On Valentine’s Day in 1994, he suffered a $600 million dollar loss when he shorted the Japanese Yen. In November that year he again incurred a $400-600 million loss.

Soros has a distinctive way of thinking about finance. His philosophically-inclined investing synthesis called “reflexivity”, is Hall of Fame material.

Soros does not subscribe to the view that markets are always right. What do we mean by ‘markets are always right’? That market prices tend to discount future developments accurately even when it is unclear what those developments are.

Soros starts with the premise that market prices are always wrong in the sense that they present a biased view of the future.


He believes that there is a 2-way interaction between the cognitive (how we perceive the environment) and the manipulative (how we change the environment).

We take actions. They are influenced by how we perceive the environment. But our perception is skewed by our biases and lack of complete information. Nevertheless, these actions impact the environment. This then changes our subsequent view of the environment. So basically, people are incapable of perceiving reality clearly. On top of that, reality is affected by these unclear perceptions.

This endless feedback loop can explain the boom and bust cycles observed in markets.

Bubbles are not the only form in which reflexivity manifests itself in financial markets, but definitely the most dramatic with disastrous consequences. Stock market bubbles don’t grow out of thin air. They have a solid basis in reality, but reality as distorted by a misconception. Every bubble consists of a trend that can be observed in the real world and a misconception relating to that trend. The two elements interact with each other in a reflexive manner.

The tech bubble of 2000 points to the collective misperception on the value of technology stocks. And as prices of the stocks ran up, investor perceptions of the potential impact of those technologies and companies begins to grow in an exponential fashion attracting more money to the industry. Which further fuels the stock price. Distortions will always find an expression in market prices.

Soros claims that being aware of reflexivity has made him an astute investor, aware of his own misconceptions and constantly and actively looking to correct them.

He does not suggest that a reflexive model replace fundamental analysis. He believes it should complement it. Fundamental analysis seeks to establish how underlying values are reflected in stock prices, whereas the theory of reflexivity shows how stock prices can influence underlying values. One provides a static picture, the other a dynamic one. Having said that, in a normal state reflexivity is not important. When it approaches far-from-equilibrium conditions, reflexivity becomes important and you have a boom/bust sequence.

Here are some insights into his investing style taken from The Alchemy of Finance: Reading the Mind of the Market and The Crash of 2008 and What it Means: The New Paradigm for Financial Markets, books he has authored. 

Work with a hypothesis

Making an investment decision is like formulating a scientific hypothesis and submitting it to a practical test. Both activities involve risk. Success brings a corresponding reward. One must view the financial market as a laboratory for testing hypotheses.

Stocks are supposed to have a fundamental value distinct from their market price. The market price is supposed to tend towards its fundamental value over a period of time. The glaring discrepancies between prevailing stock price and fundamental values are attributed to future developments that are not yet known but correctly anticipated by the stock market. After all, the “market is always right”. The problem is that most investors have no hypothesis expect that a particular stock is going to outperform the market average.

Bet big

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. Go for the jugular when extremely convicted on a bet. After all, if you are right on something, you cannot own enough. It is the magnitude of correctness that matters for an investor, not frequency of correctness. There is no point in being confident and having a small position. If the odds are substantially in your favour on a given wager, bet big.

In the first half of 2014, it was reported that Israeli pharmaceutical giant Teva was the largest holding in his portfolio. But he is no buy-and-hold investor. Within a year of it being the largest holding, exited the entire position worth some $280 million by May 2015.

Get a grasp on risk

Risk is the possibility that you may suffer harm or loss. One of the hardest things to judge is what level of risk is safe. There are no universally valid yardsticks: each situation needs to be judged on its own merit. In the final analysis you must rely on your instincts for survival.

Three situations must be faced:

(1) Sometimes you know the nature of the risky event and the probability (as in a coin flip);

(2) Sometimes you know the nature of the event, but don’t know the probability (which is uncertainty as in the price of a given stock in 20 years); and

(3) Sometimes you don’t even know the nature of what future states might hurt you.

These decisions are made in an environment where 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.

Given risk, uncertainty and ignorance, the best thing you can do is to have a margin of safety.

Critically examine

Soros called himself an insecurity analyst.

I recognize that I may be wrong. This makes me insecure. My sense of insecurity keeps me alert, always ready to correct my errors. I watch whether the actual course of events correspond to my expectations. If not, I realize I’m on the wrong track. I’m only rich because I know when I’m wrong. I have survived by recognizing my mistakes.

Where there is a discrepancy between my expectations and the actual course of events, it does not mean I dump my stock.  I re-examine my thesis and try to establish what has gone wrong. But I don’t stand still and I don’t ignore the discrepancy.

Imperfect understanding is the human condition and there is no shame in being wrong, only in failing to correct our mistakes. Unarguably, these words can be applicable to any aspect of life.

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