Customer Reviews

The Alchemy of Finance (Wiley Investment Classics)

5 star:		(9)
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3 star:		(2)
2 star:		(3)
1 star:		(3)

 

 

In this updated edition, Soros summarizes his worldly philosophy--the connection between thought and reality and how it applies to financial markets. The heart of the book remains Mr. Soros's account of what he did with Quantum Fund in the mid-1980s, both as an example of his approach and a remarkable lesson in how to make money in markets where most of the time nobody, including Mr. Soros, knows what's coming next.

His philosophical tenet, Reflexivity, denotes a feedback loop: Individuals act on their views of a situation, thereby changing the situation. For example, if traders believe a stock is going up, they buy it, thereby bidding it up. But their belief caused the result; there may be no fundamental reason for the rise.
Thus what we think determines what we do and has consequences, but typically it is not correct.

Inspired by Heisenberg's rule about quantum particles, Soros proclaims a human uncertainty principle which suggests our understanding is often incoherent and always incomplete. From his case study, one notices that uncertainty continually besets Mr. Soros in managing his hedge fund, which has the same name as the particles subject to Heisenberg's uncertainty principle.

General models do not always translate into money making practice. But Soros provides an insight of great practical significance: traders need to be adaptive, because there is no way of knowing beforehand how a market situation will turn out.

The Quantum Fund experience demonstrates how that works. This exercise in global macro strategy, a master speculator's take on commodity, currency and equity markets, is a a litany of doubts and hazards.

He's been losing on currency trades for several years. Then in September 1985, he makes a killing by buying a lot of yen just before central banks switch to a new exchange rate system and the yen rises. There is a pattern: he sustains losses, reduces positions, gets out, then sees a great opportunity and pounces. In short, he constantly and quickly adapts to events.

Despite various setbacks, Quantum Fund's NAV per share rose 121% in 1985 and 43% in 1986. Such numbers make for legend and Mr. Soros became one.

How did he do it? He keeps an open mind and continually modifies his outlook with new information. As he remarks, "the markets provide a merciless reality check," and Mr. Soros never stays with an idea that fails the test. Most of the time he can't predict what's coming, but he promptly corrects course in response to feedback. That limits losses. On rare occasions he can see through the fog of uncertainty and hauls in the booty.

This is not an easy book to read, but as another hedge fund manager, Paul Tudor Jones, describes it in the foreword, it is a timeless guide.

Anyone who has had as much success as Soros must be doing something right, so I respect his mind. Unfortunately, he is a terrible writer. He could take ten pages explaining why 2 + 2 = 4.

Here's an example:
"[the shoelace theory]...can be interpreted as a synthesis of Hegel's dialectic of ideas and Marx's dialectical materialism. Instead of either thoughts or material conditions evolving in a dialectic fashion on their own, it is the interplay between the two that produces a dialectic process."

This passage is a microcosm of the entire book: he makes a valid point, but it's not a particularly significant or difficult point. The only difficulty is in parsing his turgid language. I sense he is a great investor who wants to be considered a great thinker, and he believes that in order to accomplish this he has to use big words to express his theories.

Soros's widely praised theory of reflexivity is a valuable contribution, but he doesn't need 400 pages to convey it. I didn't read this book expecting a "how to make money in the stock market" tutorial, but I did expect to gain a better insight into how the markets function. I did not get that.

Don't waste your time.

I first read this book in 1994 and remembered it being unuseful and his kitchen-talk economics being superficial. So, 11 yrs later I picked it up again believing that it was my own lack of understanding and maturity that made me under-appreciate Soros. But, I was wrong.

Pros: Chapter Chapter 3 is about his approach to the currency market speculation. This is probably the most useful part of the book for an investor or market observer. Currencies are, after all, entirely relative to each other, particularly after the fall of Bretton Woods. He simplifies his model into eight variables (nominal FX, nominal i, price levels, gdp, capital flows, hotmoney flows, trade account, and govt budget) and then talks about how a virtual cycle appears when the market perception itself feeds price movement, which in turn fuels the perception that the perception was correct. This culminates in incorrect pricing and thus opportunity. This approach is not unlike other int'l/macro hedge fund managers today.

Cons: He has lengthy diatribes around his overabundant belief that he's a great-mind in philosophy and economics. Reflexivity is nothing more than the notion that market participants affect a price, but that prices are dynamic and constantly influenced by perception -- and here's the GREAT insight -- and perception sometimes is misled by unfounded herd momentum. He applies this model to the stocks, currencies, and credit vs regulatory cycles in the book. However, Billionaire make not a Worldly Sage...

For example, he debunks all academically-taught economics by comparing the "Perfect Competition" model to his Reflexivity. Well, of course, Perfect Competition is not reality and Supply/Demand are not discrete lines that nicely intersect on Wall Street at 4:00pm every business day! Every student of economics understands that. Its too bad that Soros's 1950's college-level economics didn't introduce him to more challenging concepts and higher level models (no offense intended towards Princeton). He does similar things to metaphysics, which can be best described as a little better than yet-another-Hollywood-actor describing existentialism.

His arguments follow an annoying pattern: (1) oversimplify a current model and debunk it, (2) apply his Reflexivity theory onto the situation, and (3) philosophize about life's implications. I can almost see him take a cigar puff then as minions sit gasping at his profound teachings, as if from Kant and Samuelson -- combined. He readily admits in the introduction and thoroughout the book that he's writing real-time and out of sequence when he has time. So, the style of writing follow an initially focused set of themes, then meander about as if he's punching the keyboard at 2:00am.

In summary, this book will NOT give you insights into the mind of one of the most profitable hedge fund traders in the world. He will not tell you his techniques (like "How to Trade like a Hedge Fund"), nor will he allow you into his inner feelings and personality (like "My Life as a Quant") so that you can walk away with something useful tomorrow. Rather, he's telling you what he wants and drags you along for a ride with verbose pages -- after pages.

In all of investment literature, there's nothing quite like the peek inside Soros's mind in his "real-time experiment." The only thing that comes close is Lefevre's _Reminiscences of a Stock Operator_. Even when Soros is wrong (like when he sees the 1987 crash as marking Japan's rise to world dominance, or in predicting a worldwide credit collapse in the late 80's), he is fascinating. The guy really is smarter than sin, and the writing gives you a sense of the kind of relentless energy as well as intellect he brought to his work.

His discussion of "Reagan's Imperial Circle," in which Reagan's aggressive military posturing coaxed inflows of foreign investment into US dollar-denominated currencies, thereby masking the massive inflation his military spending created, explains as well as anything the US's prosperity in the 1980s. It also provides a road map, written twenty years ago, to what might happen now that those inflows, as well as the internally generated credit from Fed rate cuts have stopped. Inflation? Falling dollar? Is massive government spending really the Holy Grail politicians think today? Why did it not work for Johnson or Nixon, and work for Reagan? Will it work for Bush? Reading Soros greatly improves your understanding of the landscape that these questions come from.

I'm a dyed-in-the-wool value investor, and this is one of my three favorite investing books. Probably not for beginners, though.

One trap you can fall into in life is to not learn from those that you disagree with, for one reason or another. George Soros would be an example of that. His politics are very different from mine, as well as his religious views. He's a far more aggressive investor than I am as well. I am to hit singles with high frequency over the intermediate term. He played themes to hit home runs.

The Alchemy of Finance made a big impression on me 15 years ago. Perhaps it was a book that was in the right place at the right time. It helped to crystallize a number of questions that I had about economics as it is commonly taught in the universities of the US.

First, a little about me and economics. I passed my Ph. D. oral exams, but did not receive a Ph. D., because my dissertation fell apart. Two of my three committee members left, and the one that was left didn't understand my dissertation. What was worse, I had moral qualms with my dissertation, because I knew it would not get approved.

My dissertation did not prove anything. All of my pointed to results that said, "We're sorry, but we don't know anything more as a result of your work here." I have commented before that the social sciences would be better off if we did publish results that said: don't look here -- nothing going on here. But no, and many grad students in a similar situation would falsify their data and publish. I couldn't do that. I also couldn't restart, because I had put off the wedding long enough, so for my wife's sake, I punted, and became an actuary.

That said, I was a skeptical graduate student, and not very happy with much of the common theories; I wondered whether cultural influences played a larger role in many of the matters that we studied. I thought that people satisficed rather than maximized, because maximization takes work, and work is a bad.

I saw how macroeconomics had a pretty poor track record in explaining the past, much less the present or future. In development economics, the countries that ignored the foreign experts tended to do the best. Even in finance, which I thought was a little more rigorous, I saw unprovable monstrosities like the CAPM and its cousins, concepts of risk that existed only to make risk uniform, so professors could publish, and option pricing models that relied on lognormal price movement.

Beyond that there was the sterility of economic models that never got contaminated by data. I was a practical guy; I did not want to spend my days defending ideas that didn't work in the real world. And, I felt from my studies of philosophy that economists were among the unexamined on methodology issues. They would just use techniques and turn the crank, not asking whether the metho, together with data collection issues made sense or not. The one place where I felt that was not true was in econometrics, when we dealt with data integrity and model identification issues.

Wait. This is supposed to be a book review. :( Um, after getting my Fellowship in the Society of Actuaries, I was still looking for unifying ideas to aid me in understanding economics and finance. I had already read a lot on value investing, but I needed something more.

On a vacation to visit my in-laws, I ended up reading The Alchemy of Finance. A number of things started to click with me, which got confirmed when I read Soros on Soros, and later, when I began to bump into the work of the Santa Fe Institute.

I was already familiar with nonlinear dynamics from a brief meeting with a visiting professor back in my grad student days, so when I ran into Soros' concept of reflexivity, I said "Of course." You had to give up the concept of rationality of financial actors in the classical sense, and replace them with actors that are limitedly rational, and are prone to fear and greed. Now, that's closer to the world that I live in!

Reflexivity, as I see it, is that many financial phenomena become temporarily self-reinforcing. We saw that in the housing bubble. So long as housing prices kept rising, speculators (and people who did not know that they were speculators) showed up to buy homes. That persisted until the effective cashflow yield of owning a home was less than the financing costs, even with the funky financing methods used.

Now we are in a temporarily self-reinforcing cycle down. Where will it end? When people with excess equity capital look at housing and say that they can tuck it away for a rainy day with little borrowing. The cash on cash yields will be compelling. We're not there yet.

Along with that, a whole cast of characters get greedy and then fearful, with the timing closely correlated. Regulators, appraisers, investment bankers, loan underwriters, etc., all were subject to the boom-bust cycle.

Expectations are the key here. We have to measure the expectations of all parties, and ask how that affects the system as a whole.

In The Alchemy of Finance, Soros goes through how reflexivity applied to the Lesser Developed Country lending, currency trading, equities, including the crash in 1987, and credit cycles generally. He gives a detailed description of how his theories worked in 1985-6. He also gives you some of his political theorizing, but that's just a small price to pay for the overall wisdom there.

Now, Soros on Soros is a series of edited interviews. The advantage is that the interviewers structure the questioning, and forces more clarity than in The Alchemy of Finance. The drawback (or benefit) is that the book is more basic, and ventures off into non-economic areas even more than The Alchemy of Finance. That said, he shows some prescience on derivatives (though it took a long time to get to the promised troubles), though he missed on the possibility of European disintegration.

On the whole, Soros on Soros is the simpler read, and it reveals more of the man; the Alchemy of Finance is a little harder, but focuses more on the rationality within boom/bust cycles, and how one can profit from them.

Definitely not a book for novices of investment. I would like to say not a book for anybody, but that seems to be too harsh. May be it is fair to say you can still do well in investment without knowing his methods. His way is not for a regular individual investor, not for the faint-hearted at least.

But there are some valuable lessons you can learn from reading his not so easy-to-understand writing. He talked about a phenomenon in business world, in which an industry feeds on its own success and grows bigger and its stock prices higher, until it tumbles. Then, the fall will trigger more to fell, until it seems there is nothing left. Sound familiar to the dot com bloom and burst of 2000? Actually, he was talking about the electronic industry bloom-burst cycle in the 1960s in America.

An electronic firm buys components from other electronic firms. When one was successful, say, its new TV model is a big hit, it buys more from its suppliers. And it get imitates and its competitors are buying more from their suppliers. Suddenly, there are many electronic firms and everyone seems to have a bright future, i.e. ever growing sales. This in turn makes investment in electronic firms seem a sure ticket to win. And they do, their stock prices just shoot off the roof.

But then, the public can only take so many new TV, even you buy an extra one for your mother-in-law, because it is a cool new trend, there is a limit how many they can sell. Then one of the TV manufacturer fells, so are their suppliers, and the suppliers¡¦ suppliers. Once the chain reaction begins, there is no going back. Companies fell and their earnings become losses. Stock prices of electronic firms tumble and tumble. With that goes the money of many papas and mamas, and ¡§intelligent¡¨ investors like you and me.

George Soros¡¦ way is to buy during the up-trends, take profit and wait for a while, then sell shorts during the downward cycle. He described what he did during those days in details.

Another boom-burst cycle he described is on LBO ¡V ¡§Leverage Buy Out¡¨ in the 80s. I am going to leave you to read the book to find out.

Or until, I have time and read it again.

There is an account of his biggest winner ¡V the bet on Pound against Bank of England. But it is not very good, because I can¡¦t remember a thing about it.

I have been reading Soros book for many weeks now and I still find myself in a world of confusion, realizing more but daunted by my obvious lack of understanding.
Let me first be clear that I am a student of economics and mathematics and the models that Soros 'debunks' are my departments bread and butter. I think many people have misunderstood the motive behind the work. Soros is perhaps struggling to come to terms with his own thought process (a task which is certainly not easy).
Having read a few reviews, it seems that many other readers have misunderstood the theory of reflexivity, and perhaps Soros motives for explanation.
Soros makes a great point that in natural science we prescribe laws that mimic nature as closely as possible i.e. F=ma will give us a consistent result each time, we can therefore move from theory to practice without great loss of accuracy (for lack of a better word). Soros says that the goal of science is to move ever closer to the truth. At the end of the day though nature does not care what equations we have crowbarred in to approximate nature. There is in essence a one way relationship.
In social science (and this is where reflexivity comes in) the same cannot be said. There is a dynamic relationship whereby each participant affects the other - a circular influential relationship.
Soros tries to debunk the economic models which govern our central banks, fiscal policy, social and economic constructs etc... by pointing to historical results. Underpinning all his philosophy is the fundamental belief that humans are fallible and that assumptions will be inaccurate, if this is the case then economic models will also be incorrect. He does not claim to hold the perfect knowledge, but believes current economic models are overly trusted.

The reason that I gave this book 4 stars is that I am honestly struggling to fully understand Soros thought process let alone his decision making. There certainly is a lot to take in, however having battled with the book, I really believe I am a more SOPHISTICATED investor. I cannot claim to be necessarily more successful after having read it, but that would be too easy.
Just as playing basketball with jordan will make you a better basketballer, one cannot necessarily expect to emulate Soros just by reading his book.
I am now more aware of the subtle philosophical ebb and flow which is 'underground' and for that, this book alone is worth the price.

The book focuses on how to utilize fund flows.

Very different from what Value Investors considers "value", different in a way that many Values rejected this idea, but to those who are interested in using the power of speculating to maximize your investment power, I recommend you to try this out.

How to become a billionaire? don't look here. In the end Soros provides no cookbook ways to become a billionaire. He is very intuitive and that ultimately determines his success. In the book, Soros documents his investment experience as if each is a scientific experiment. The price movement ultimately determines if his theory is correct. If he is wrong he dumps his investment. Extreme discipline. Most of us claim the market (or Mr. Market as Buffet says) is wrong and over time we will be right. Soros claims that price makes its own realities. The way he uses leverage is also a mystery at times he appears to be completely un-leveraged - rare in the hedge fund world.

The only gold in the book is his discussion of feed back loops. This I feel is so relevant to today's financial and real estate crisis. In a rising housing environment Loan to Value ratios go down, this creates success for the lender. The desire to loan is high and the supply of available money drives up prices further feeding this loop. In a declining real estate model the loan to value ratio increases exposing the lenders risk making it undesirable to lend no matter what the interest environment. The lender is stuck he can hope that his loan portfolio will be paid down or he can sell them for a loss in the open market. With loans hard to find and lenders wanting more money and higher qualifications from borrowers this assures there will be fewer buyers (buyers market). This feeds the downward loop with loan to value ratios rising even more as prices fall.

Although the book is a bit lengthy, Soros concept of reflexivity in financial markets is a highly relevant one.