Continuation in our series of portfolio management highlights from George Soros’ Alchemy of Finance – Chapter 1, Part 2: Soros discusses the flaws of human psychology, how it complicates the task of investing in a marketplace of other thinking participants, why historical performance is not indicative of future results. He also explains why the term “alchemy” is in the title of the book.
Psychology
“Natural scientists have one great advantage over participants: they deal with phenomena that occur independently of what anybody says or thinks about them. The phenomena belong to one universe, the scientists’ statements to another. The phenomena then serve as an independent, objective criterion by which the truth or validity of scientific statements can be judged. Statements that correspond to the facts are true; those that do not are false. To the extent that the correspondence can be established, the scientist’s understanding qualifies as knowledge…scientists have an objective criterion at their disposal.
By contrast, the situation to which the participants’ thinking relates is not independently given: it is contingent on their own decisions. As an objective criterion for establishing the truth or validity of the participants’ views, it is deficient…one can never be sure whether it is the expectation that corresponds to the subsequent event or the subsequent event that conforms to the expectation.
Thinking plays a dual role. On the one hand, participants seek to understand the situation in which they participate; on the other, their understanding serves as the basis of decisions which influence the course of events. The two roles interfere with each other…If the course of events were independent of the participants’ decisions, the participants’ understanding could equal that of a natural scientist; and if participants could base their decisions on knowledge, however provisional, the results of their actions would have a better chance of corresponding to their intentions. As it is, participants act on the basis of imperfect understanding and the course of events bears the imprint of that imperfection…
Participants have to deal with a situation that is contingent on their own decisions; their thinking constitutes an indispensable ingredient in that situation. Whether we treat it as a fact of a special kind or something other than a fact, the participants’ thinking introduces an element of uncertainty into the subject matter…Perhaps the most outstanding example of the observer trying to impose his will on his subject matter is the attempt to convert base metal into gold. Alchemists struggled long and hard until they were finally persuaded to abandon their enterprise…”
Historical Performance
“A world of imperfect understanding does not lend itself to generalizations which can be used to explain and to predict specific events. The symmetry between explanation and prediction prevails only in the absence of thinking participants. Otherwise, predictions must always be conditioned on the participants’ perceptions; thus they cannot have the finality which they enjoy in the-D-N model. On the other hand, past events are just as final as in the D-N model; thus, explanation turns out to be an easier task than prediction. Once we abandon the constraint that predictions and explanations are logically reversible, we can build a theoretical framework which is appropriate to the subject matter.”
This is why historical performance is not indicative of future results, and why performance chasing produces sub-optimal results. As Mark Twain said, “History doesn’t repeat itself, but it does rhyme.” It doesn’t repeat because markets are full of thinking participant forever shifting and adjusting their thinking, but it does rhyme because our fundamental psychological pathways remain unchanged over the span of centuries.