Saturday, October 25, 2014

Influenced by the Future

Forecasting is a critically important skill for a businessperson or an investor. But almost all forecasts are wrong to some degree. Why is it so difficult?

George Soros, in his book The Alchemy of Finance, postulates a theory of reflexivity that sheds light on some of the reasons why predicting the future is almost impossible. Reflexivity observes that people make predictions based upon their expectations of the future. The actions people take based upon those predictions actually change the course of events to create a different future. Actions, influenced by future expectations, of millions of people interact in ways that are far too complex to model.

Reflexivity is easiest to observe in the stock market where it leads to the boom and bust cycles that we saw in the technology boom of the late 90s and the housing bubble that caused the great recession. Although the book was originally published in 1987, before either of these crashes, those events fit the theory precisely.

Reflexivity predicts that in the early build up of a boom/bust cycle, there is accelerated growth in a sector that accurately reflects the fundamental growth potential. The accelerated growth creates an expectation of future growth that pushes prices higher than the fundamentals support. After a period of growth, there is usually a price correction that stokes fear of a price crash. When the prices recover from the correction, investors are relieved and the growth cycle begins anew. The very fact that the correction didn't cause a crash makes investors less wary. Prices continue to increase, fueling expectations of more increases until the the difference between the price and the value becomes to great to ignore leading to a catastrophic crash.

If we consider the reflexivity model and 3D printing stocks, it would appear that the period from 2008 through 2013 represents the initial period of accelerated growth. The dramatic decline in prices during the first quarter of 2014 represents the correction. It follows that the stocks should now enter the second period of rapid growth.

What is your favorite growth investment?

You might also like:
Looking Forward
The Paradox of Certainty
The Thrill of Ownership