Behavioral finance FAQ / Glossary (Reflexivity)
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Reflex, reflexive bias
see automaticity, reflexivity,
A reflex is an automatic reaction to a stimulus, either physical or
emotional (for example a disturbing or pleasant information)
An inappropriate reflex is a reflexive bias
For details see the"automaticity" article of this glossary
00/6i,9i,12i - 01/3i,6i,10i -
02/2i,10i- 03/3i - 08/08i +
see feedback, self-fulfilling
prophecy, observer bias,
The Merry-Go-Round towards mentally modified realities
Perception becoming realities
As a simple definition, reflexivity is a rather common process in
1 People have a perception or make a
representation (see those words). of the situations
they observe or in which they act as players.
2 The situation evolves and, here it is a bit eerie,
adapts itself so as to match this
perception / representation of observers / players,
even when it was wrong.
3 This new situation alters in its turn the perception.
It could be said to be a "double feedback" process (see feedback), a double
reflex, fuelled by the perceptions and representations
It is also called circularity, self-reference effect.
As if two chameleons endlessly adapt their colors to each other on the way
to the madhouse!
When the observer or player
affect the horses in the race
No magic here, no telepathy: as seen also in the "observer / observed" effect, the
observer alters the situation it observes (see, observer bias, Goodhart law...).
The player(s) change(s) something in the playing field, which alter its/their
As George Soros explained:
At the start there is an "inherent divergence , between
the participants' views and the actual state of affairs".
But at the end "the participants' thinking affects the situation
to which it refers".
In financial markets, as seen below, stock prices, which are linked
to investor perceptions, can affect the corporate situation,
The market players perceptions about an asset can change the
This in its turn can affect stock prices and the investor situation (a triple
The process reinforces itself
Seems like magic, why not use the wand again?
There is another trait in this social phenomenon: reflexivity reinforces itself
step by step.
That spiral happens:
When a decision on a given field (for example in a stock market) creates
events that comfort the initial decision, like in a self-fulfilling
Those new events can happen in the same field (here the stock market), or
in a related field (for example in a company's prospects).
Therefore those deciders consider that event / information
as a confirmation.
This incites them to make again a similar decision,
and so on.
Reflexivity and positive feedback loops
Creating new species
There is some "information loop" implied in that circular "perception - situation"
It is a form of intertwined positive feedbacks (see that word) specific to human
and social behavior, by which the decider gets a result which encourages him
to take again the same decision with the same result.
Here is the process step by step:
The general process
A financial example (**)
1) The entity A (*)
(*) Either an individual,
an organization, or a
bunch of people or
Investors sees a
corporation as well
managed and deems
that its earnings will rise.
This pushes its
exactly as fancied..
2) That decision affects
events via an entity B (*).
(*) An institution /
mass of people...
The corporation uses its
high priced stock as
money to buy other
by exchanging a few of
fits own stocks for it.
per share rise.
3) Those events cause
(good or bad) effects
to that entity A
The earnings per share rise
incite other people to
It pushes its price
It benefits those who
bought in phase 1
4a) The entity A or B
or both get convinced
they were right.
take again decisions
in the same direction.
Its behavior becomes
thus repetitive and
The firm buys again other
Investors see those moves
favorably, as the previous
ones effectively boosted
They see the pursuit of this
practice as a confirmation
of good earnings growth
Investors buy more
stocks and make
their prices rise
The 1) 2) 3)
4b) Or gets convinced
that it was wrong.
Then it adjusts its
decisions and the
circle is broken.
One day the process gets
excessive, or somebody
admits that the king is naked,
or a sand grain blocks the
For ex. the reputed well-
managed corporation hits
The process stalls,
(**) Other cases are found, for example in the relations between
general economic evolutions and general stock market or
But don't trust hocus pocus and abracadabra too much.
Observer interferences and self-fulfilling prophecies often
distort realities but not always in such extreme ways.
The incidence might break, abort or revert at any step.
Does it occur in other markets
than stock markets?
Reflexivity can occur in all markets: real estate, commodities,
But it is usually less acute, financial speculation finds here its limits as the
physical supply and demand is bounded by cold realities.
There are limits to what physical users / producers can accept, the offer
and demand is not fully "inelastic"
We have here what we can call "reflexivity under constraint"
In financial markets, there are
three degrees of reflexivity
1) Prices follow prices,
2) Prices follow models,
Models follow prices,
3) Fundamentals follow prices,
Prices follow fundamentals.
And you, did you follow what I just said? Not sure I did myself ;-)
1) Not only fundamentals influence stock prices, butalso current stock prices influence future
Even when they are biased (mispricing), current prices create a
mental anchoring on them (price stickiness).
This influence of past stock prices on future ones is an example
of self-fulfilling prophecy.
The market adapt its face to its own reflection in its mirror
Of course, this mind conditioning doesn't work always.
Markets can alter their course,
* for example when funds to support the trend get exhausted,
* or because of an external shock,
* or because some players become cautious or even
2) Some methods, models or paradigms usedfor pricing and or / trading can be reflexive:
They might be used (or even be invented ) as an explanation,
but sometimes the wrong one, of market prices and momentums.
Reciprocally, as people accept that rationalization (see that word)
and use them, they might contribute to the formation of market prices
and price momentums.
3) The extreme / strong form of reflexivity is
when stock prices influence
The (financial) dog wags the (economic) tail, the
snake bites its own tail, you choose the allegory !
As seen in the above example, the fact for a company to
be highly priced has advantages: make it find more (and
cheaper) funds, or it can easily launch financial operations
such as takeovers.
This is how full reflexivity combines financial and
A consequence for economic theories
Economic alchemy and capital mutation.
No need to say that the reflexivity theory is a dent in the efficient market
Also, reflexivity in financial markets has contributed to change the nature
of capital .
Classical economists missed a few things when they defined capital, the same
as they missed things in their theories of value.
One good reason was that capital was not as easily tradable as today.
But the old definitions are still used in textbooks, as a mental anchoring.
The issue can be said to be between looking backwards (the old
model) or forwards (the current model):
Can capital be defined - as
was the old idea - as (only)
what has been invested
or reinvested in means of
Should we consider capital
as an historical
accumulation of means
in firms' balance sheets?
Or is capital an expectation, a
a valuation of economic
This is what capital market
Such a valuation uses objective
criteria (cash flow discounting,
taking risk into account) as
well as behavioral criteria.
This prospective approach
can lead to compute the
capital committed into a
firm (its equity) by first
measuring its goodwill as
expressed by the market price.
The recent market based accounting standards (IAS / IFRS) are orientated
towards the last definition.
Investor usually invest for the future, not for the beauty of the balance sheet's
Of course there are limits:
When a market is highly chaotic, volatile and fast
moving are its prices a reliable measurement?.
Can they be considered as serious forward-looking valuations?
Can they end up in a feedback upwards or downwards spiral?
Also, there might be cases when the "backward / cumulative
value" keeps some of its importance, namely when to accumulate
assets (real estate...) is the company's stated purposeand if those
assets are resalable.
Of course, here also, there is anticipation / speculation by investors
who play on the future value of those assets, sweetened or not by
intermediate cash flows they are expected to bring.
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