Reflexivity is an economic theory developed by George Soros that argues that markets are isomorphic with human minds in that the functioning of one affects the other. In essence, it states that positive feedback loops between perception, expectations, and fundamentals can cause markets to deviate substantially and for extended periods of time from fundamental value equilibrium. This differential can manifest itself in a variety of ways, such as booms, bubbles, and crashes.

The idea of reflexivity counters the basic assumption of traditional economics that sees markets as comprised of autonomous, individual elements that act in a rational way. In contrast, Soros’ reflexive theory is based on John Maynard Keynes’ observation that markets are composed of participants whose expectations about the future inform and shape their present decisions. The expectations of participants, in turn, create a feedback loop, wherein their present decisions influence the future outcome. The collective expectations of market participants not only affect prices, but can also create an alternate reality or “bubble” in which prices are disconnected from typical measures of value.

Reflexivity also counteracts the idea of equilibration of pricing. Traditional economics teaches us that prices will eventually settle into an equilibrium, but the theory of reflexivity states that self-reinforcing loops in the market can cause prices to be pushed away from equilibrium points for significant periods of time. This explains why speculative bubbles are able to form, as well as why recessions can be so difficult to escape.

In a way, reflexivity is an acknowledgement that human behavior, both inside and outside of the market, plays an essential role in the functioning of markets, which means that insights from the behavioral sciences can be used to gain valuable insights into market dynamics. Using reflexivity as a framework, investors can gain a better understanding of how their expectations are impacting their prices. This knowledge can be used to their advantage if used correctly. For instance, anticipating a “bubble” in a certain security may provide an opportunity for an investor to capitalize on the anticipated rise in prices, while at the same time hedging against a possible collapse.

In conclusion, reflexivity is an economic theory developed by George Soros that attempts to explain how market sentiments and expectations can help to shape the reality of prices and markets. This theory has gone on to become one of the contributing factors behind Soros’ success as an investor, and provides an interesting insight into the impact of human behavior and expectations on the markets. Thus, it may be beneficial for investors to gain an understanding of this theory so they can use it to their advantage.