Posted in Finance, Accounting and Economics Terms, Total Reads: 313
Reflexivity, in finance, refers to the fact that the biases of the investors and traders in a financial market can change the fundamental ways in which a financial market determines the market prices.
The basic theory of reflexivity says that the values and thoughts of a person tend to get reflected in the work he/she does. The thoughts and ideas of a person are inherently biased and that unknowingly appears in and affects his work. It was George Soros who introduced the concept of reflexivity in the trading of the financial markets, when he attributed his own financial success to the understanding of the action of the reflexive effect.
The concept of reflexivity is based on three ideas:
a. It is best observed when the biases of the investors grow and spread throughout the financial market.
b. It appears periodically as it is most likely to be revealed under certain conditions.
c. The observations of the investors may influence valuations and fundamental outcomes of the market.
Reflexivity tries to explain the movement of the markets from the equilibrium states either to the upper extreme or towards the lower extreme.
Example: The most recent example of reflexivity can be seen in the debt and equity of the US housing market. The banks started offering frequent loans to people for buying houses. Thus more people started buying houses and this increased the price of the house properties. The banks , looking at their balance sheets found out that they had offered more loans, but also had more equity (house properties) backed up for the loans. And thus they gave away more loans and which in turn increase the housing prices. This led to the relaxation of the lending standards , which ultimately stirred up the beginning of the 2008 crisis.