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Andrew Moe: Reflexivity  

In the ever persistent effort to increase the predictive power of my crystal ball, I recently completed the study of reflexivity by the great alchemist Soros. Throughout, thoughts of the efficient market hypothesis haunted my mind: "in the absence of exogenous shocks, financial markets tend toward an equilibrium that accurately reflects the participants' expectations."

For an object to be at equilibrium, the resultant force and moment vectors must both be zero. In the markets, this never happens. Even on the most thinly traded days when volatility shrinks to nil, prices swing back and forth as perceptions oscillate between bullish and bearish. I have been unable to quantify a single instance where the markets have reached and maintained a state of equilibrium.

I see price movements as a struggle to reach equilibrium, but one which always overshoots the intended target, only to swing back and overshoot again. The market actually spends very little time at equilibrium. In fact, it's usually moving at its greatest speed as it crosses the point of perceived equilibrium - much like a pendulum as it crosses its resting point. The difference in the markets is that the equilibrium point is not fixed. Each swing moves the perceived equilibrium as the actions of the participants shape their future perceptions.

In addition, the pendulum is not swinging in a vacuum. It is buffeted from all sides by the winds of external events. At times, the winds can actually change the direction of the pendulum. Other times, the pendulum has so much momentum, it cuts through even the strongest of winds. Most of the time, they act to either dampen or enhance the motion. Still, the pendulum swings from side to side with an eerie regularity.

The equations of motion for a simple pendulum can be found below. In applying them to the markets, the trick is to define equilibrium, keeping in mind that it moves along with price.



Comment by Shui Mitsuda:

Mr. Moe,

When I was a poor university student at UCL, I used to do busking at Convent Garden London England performing Chinese classical music, collecting donation and sell tapes in order to support my daily life.

Out of miserable busking where people tend to look down on performers, I learned a precious lesson, which permanently affected my career and market philosophy.

* Our quality and value of products (music performance and audio tape) we provided were essentially the same through out the time but participants (audience and customers) reaction and degree of appreciation for our products were totally different from time to time & day to day. Some time no appreciation, no donation, no sales of tapes what so ever. Some time, full of loud praise, huge sales of tapes having not enough stock.

Important thing as a performer and a sales man was to clearly understand and believe in the value of product and service we were providing and not to get swung and intimidated by audiences' reaction.

If audience show no interest, fine, we would stop the music performance in the middle of the music and wait for a while till next potential audience who had shown interests our Chinese ancient instruments (2 string violin, month held organ etc). Because these audiences will trigger others' interest. Sometime I pretended as an audience to pull in audience. A little sales tactic.

There were many types of audiences, some listen because simply our music appeared to them. some listen simply (or foolishly) because others are listening. Some pay simply because music was good. Some pay donation out of sympathy, some pay because I ask them.

As a busking sales man, most important thing was to sense the character of individuals, change the way of responding to them appropriately (some time softly ask, some time don't ask but show others are buying etc), and eventually lead the MASS CROWD to the place we intended them to be.

If they don't get led in where we want them to be, simply we preserve the energy by stopping and wait for the next opportunity.

No need to play until your throat gets totally dry. But I saw many performers who did it, gets no appreciation (because quality of performance goes down), and no money. And eventually they lose confidence and quit busking. (I also see many similar type of people in financial market.)

Many other factors affect the sales too. Day of a week (fri, sat, sun are usually good), time (week day lunch time is good, week end lunch to 7pm). weather, calendar, season, and not to forget general economy.

All the factors affect the sales.

I believe quantification of general phenomenon helps. But what Soros concluded in the reflexivity is not a definitive equation that can work out where the price stands but rather it was to generally express the phenomenon of market activity in simplified equation/graphic form.

* In other words, it is not possible to QUANTIFY where the markets have reached and maintained a state of equilibrium. And still ability of having being able to sense where participants stand (mostly emotionally) is one of most important skills speculators as well as investors must possess.

* If someone argue me how to get the skill, I would answer, be at and observe the market as frequently as possible, watch the news and think (never to trust fully but seek the reality), go travel around the world & see and talk to people, sit down and think what is your emotional status (because yourself is also a mkt participant) and compare with mkt (you may be a contralian or you could be one of crowd). Basically all the things are absolutely basic but I know many do not stick to basics properly.

I have never met George Soros in person but I am sure he is one of the sharpest who can sense where the mass crowd stands and take appropriate action. This also means the fact Soros is heavily criticising G W Bush is that he senses a critical warning sign that crowds are going towards wrong direction under G W Bush's policy and Bush himself is not good at sensing the crowds neither lead the crowds where they should be.

Rgds, Shui  


Comment by Russ Sears:

No in between. I finally took to having an assistant looking or "waiting on line," which stimulated others to become interested, and my bankroll grew. When I learned about the Poisson distribution, it was taught to me that often the worker, waiting for a customer, has a mental bias to over estimate the "if it rains it pours" effect of consumers' willingness to wait in line. Yet, the effect does occur in matters of fashion and taste. But in matters of necessity, such as gassing up the car, the waiting lines usually are better modeled by seasonality. That is frequency of customers are better explained by time of day/ week etc. than by lack or length of a line. Overcoming this "mental bias" seems to be a problem for me when the position is going against me, but still recognizing when it is a "lost cause."