Behavioral finance FAQ / Glossary (Reflexivity)

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Reflex, reflexive bias

see automaticity, reflexivity,
reaction, feedback

Definitions

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

Reflexivity, circularity



00/6i,9i,12i - 01/3i,6i,10i -
02/2i,10i- 03/3i - 08/08i
+
see feedback, self-fulfilling
prophecy, observer bias,
perception, reflex

The Merry-Go-Round towards mentally modified realities

Definition

Perception becoming realities

As a simple definition, reflexivity is a rather common process in
several steps

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
own situation.

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
  
asset's fundamentals.

This in its turn can affect stock prices and the investor situation (a triple
   feedback
).

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
  prophecy.

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"
phenomenon.

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 (*)

decides something.

(*) Either an individual,
an organization, or a
bunch of people or
of organizations..)

Investors sees a
corporation as well

managed and deems

that its earnings will rise.

They buy
its stocks.

This pushes its
price
up,
exactly as fancied..

 



2) That decision affects
events
via an entity B (*).

(*) An institution /
corporation, another
mass of people..
.


The corporation uses its
high priced stock
as
money to buy other
profitable firms
by exchanging a few of
fits own stocks for it.

The combined

earnings
per
share rise.

3) Those events cause
(good
or bad) effects
to that entity A

 


The earnings per share rise
incite other people
to
buy the
corporation's stocks.

It pushes its price
  up
again.
It benefits those who
bought in phase 1

4a) The entity A or B
or both get convinced
they were right.

(self-fulfilling
prophecy
):they
take again decisions
in the same direction
.

Its behavior becomes
thus repetitive and
feeds reflexivity

The firm buys again other

firms

Investors see those moves
favorably, as the previous
ones effectively boosted
earnings.

They see the pursuit of this
practice as a confirmation
of good earnings growth
prospects.

Investors buy more
   stocks and make 
   their prices rise

  again.

The 1) 2) 3)
    process starts
    again


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
gear.

For ex. the reputed well-
managed corporation hits
some problems.

The process stalls,
   freezes or
  
reverts.

 

 

(**) Other cases are found, for example in the relations between

general economic evolutions and general stock market or
currency markets.

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,
foreign exchange...

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, but

      also current stock prices influence future
     prices
.

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
  contrarians...

2) Some methods, models or paradigms used

          for 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
...fundamentals .

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
economic anomalies.

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
hypothesis.

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):

Backwards-looking
"capital"

Forwards-looking 

"capital"

Can capital be defined - as

was the old idea - as (only)

what has been invested
or reinvested
in means of
production?

Should we consider capital

as an historical
accumulation
 of means
in
firms' balance sheets?

 





Or is capital an expectation, a
   
a valuation of economic
    prospects?

This is what capital market
investors anticipate

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
hard assets.

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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