Reflexivity

Reflexivity is an economic theory that describes how market participants’ perceptions influence economic fundamentals, and how those changing fundamentals in turn reshape perceptions and prices. Coined for finance by investor George Soros, reflexivity emphasizes feedback loops that can drive markets away from equilibrium and create persistent price distortions.

Key points

• Investors act on perceptions, not objective reality; those actions change fundamentals, which then alter perceptions again.
• Positive feedback loops can amplify trends, producing booms, bubbles and subsequent crashes.
• Reflexivity challenges the assumptions of economic equilibrium and the efficient market hypothesis (EMH), which assume prices reliably reflect fundamentals.
• Leverage, credit availability, and expectations often play central roles in reflexive episodes.

How reflexivity works

1. A shift in expectations or beliefs prompts trading behavior (e.g., rising housing price expectations).
2. That behavior affects real economic variables (more mortgage lending, higher demand).
3. Changed fundamentals reinforce the original expectations, creating a self-reinforcing loop.
4. The cycle can continue until the disconnect between prices and underlying reality becomes unsustainable and reverses, often abruptly.

Positive feedback (reinforcement of a trend) dominates in reflexive episodes, overwhelming the negative feedback mechanisms that would normally restore equilibrium.

Contrast with mainstream theory

Mainstream economics and the EMH assume prices tend toward equilibrium because participants use available information to form rational expectations; price changes reflect new fundamentals and lead markets to re-balance. Reflexivity contends that expectations themselves can alter fundamentals, producing persistent departures from any equilibrium and making prices less reliable indicators of intrinsic value.

Historical and practical examples

• Housing bubble and the 2007–2008 global financial crisis: Rising home prices encouraged increased lending and speculative demand, which pushed prices higher—until the cycle reversed and prices collapsed.
• Asset bubbles and crashes more broadly: Availability of credit and leverage often magnify reflexive dynamics, accelerating both the build-up and the unwind.
• Currency and credit cycles: Floating exchange rates and credit expansions can interact with expectations to produce prolonged misalignments.

Implications for investors and policymakers

• Markets can remain irrational longer than expected; prices may not quickly reflect fundamentals.
• Reflexivity increases volatility and can create systemic risks when leverage is widespread.
• Investors should consider how sentiment, leverage and feedback loops might amplify trends rather than assuming immediate mean reversion.
• Policymakers and regulators should monitor credit conditions and leverage that can fuel reflexive cycles.

Conclusion

Reflexivity offers a framework for understanding how perceptions and fundamentals interact to create self-reinforcing market dynamics. It highlights the role of human beliefs, credit and feedback loops in producing booms and busts, challenging the idea that markets always efficiently and quickly reflect underlying economic realities.