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.