What is 'Reflexivity'

Reflexivity is the theory that a two-way feedback loop exists in which investors' perceptions affect that environment, which in turn changes investor perceptions.The theory of reflexivity has its roots in social science, but in the world of economics and finance, its primary proponent is George Soros. 

BREAKING DOWN 'Reflexivity'

Reflexivity theory states that investors don't base their decisions on reality but their perceptions of reality. The actions that result from these perceptions have an impact on reality, or fundamentals, which then affects investors' perceptions and thus prices. The process is self-reinforcing and tends toward disequilibrium, causing prices to become increasingly detached from reality. Soros views the global financial crisis as an illustration of the theory. In his view,investors assumed that on a nationwide basis housing prices would never decline. And as they came to believe a financial instrument made up of subprime mortgages, if properly packaged, could be as safe as their AAA credit rating implied, prices of those assets became detached from reality. This bubble eventually collapsed, resulting in the financial crisis.

This theory runs counter to mainstream economic theory. This theory states that economic participants are on the whole rational and that they make decisions that in the aggregate amount to good choices. It also holds that free markets are effective at balancing supply and demand, at pricing assets correctly, and that they are self-correcting, resulting in equilibrium. And at equilibrium, market prices reflect fundamentals, but do not change fundamentals.

RELATED TERMS
  1. Accelerator Theory

    The accelerator theory is an economic theory whereby as demand ...
  2. Rational Expectations Theory

    The rational expectations theory posits that individuals make ...
  3. Accounting Theory

    Accounting theory is the field of assumptions, methodologies ...
  4. Market Segmentation Theory

    Market segmentation theory is a theory that there is no relationship ...
  5. Decision Theory

    Decision theory is an interdisciplinary approach to determine ...
  6. Biased Expectations Theory

    The biased expectations theory is a theory that the future value ...
Related Articles
  1. Investing

    Efficient Market Hypothesis

    An investment theory that states it is impossible to "beat the market".
  2. Trading

    The Nash Equilibrium

    Nash Equilibrium is a key concept of game theory, which helps explain how people and groups approach complex decisions. Named after renowned mathematician John Nash, the idea of Nash Equilibrium ...
  3. Investing

    Is It Wise to Copy George Soros's Investment Strategy?

    One of the most successful investors ever is George Soros. Does that means you should follow his investing strategy?
  4. Investing

    Oil As An Asset: Hotelling's Theory On Price

    Not sure where oil prices are headed? This theory provides some insight.
  5. Managing Wealth

    Modern Portfolio Theory: Why It's Still Hip

    Investors still follow an old set of principles, known as modern portfolio theory (MPT), that reduce risk and increase returns through diversification.
  6. Insights

    Soros's 13F Shows Continued Bearishness on Markets

    George Soros has apparently decided that 86 is indeed too young to retire.
RELATED FAQS
  1. What's the difference between agency theory and stakeholder theory?

    Agency theory and stakeholder theory are both used to understand and explain various types of relationships and challenges ... Read Answer >>
  2. What is the chaos theory?

    The chaos theory is a complicated and disputed mathematical theory that seeks to explain the effect of seemingly insignificant ... Read Answer >>
  3. What is general equilibrium theory in macroeconomics?

    Achieving equilibrium of prices in a single or multi-market setting involves a bidding process that is informed precisely ... Read Answer >>
  4. How does money supply affect inflation?

    Learn about two competing economic theories of the role of the money supply and whether money supply causes inflation in ... Read Answer >>
  5. How Does the Law of Supply and Demand Affect Prices?

    Learn how the law of supply and demand affects prices, as when one outweighs the other, prices can rise or fall in response. Read Answer >>
Trading Center