Portfolio management highlights from George Soros’ Alchemy of Finance – Chapter 1: The Theory of Reflexivity. In part 1, Soros discusses the concept of price equilibrium, supply and demand, and why market prices fluctuate. Intrinsic Value
“The concept of an equilibrium is very useful. It allows us to focus on the final outcome rather than on the process that leads up to it. But the concept is also very deceptive…Equilibrium itself has rarely been observed in real life-market prices have a notorious habit of fluctuating. The process that can be observed is supposed to move toward an equilibrium. Why is it that the equilibrium is never reached? It is true that market participants adjust to market prices but they may be adjusting to a constantly moving target…
…modern economists resorted to an ingenious device: they insisted that the demand and supply curves should be taken as given…They argued that the task of economics is to study the relationship between supply and demand and not either by itself. Demand may be a suitable subject for psychologists, supply may be the province of engineers or management scientists; both are beyond the scope of economics. Therefore, both must be taken as given.
Yet, if we stop to ask what it means that the conditions of supply and demand are independently given, it is clear that an additional assumption has been introduced. Otherwise, where would those curves come from? We are dealing with an assumption disguised as a methodological device…
The shape of the supply and demand curves cannot be taken as independently given, because both of them incorporate the participants' expectations about events that are shaped by their own expectations.
Nowhere is the role of expectations more clearly visible than in financial markets. Buy and sell decisions are based on expectations about future prices, and future prices, in turn, are contingent on present buy and sell decisions. To speak of supply and demand as if they were determined by forces that are independent of the market participants' expectations is quite misleading.
The very idea that events in the marketplace may affect the shape of the demand and supply curves seems incongruous to those who have been reared on classical economics. The demand and supply curves are supposed to determine the market price. If they were themselves subject to market influences, prices would cease to be uniquely determined. Instead of equilibrium, we would be left with fluctuating prices. This would be a devastating state of affairs. All the conclusions of economic theory would lose their relevance to the real world.”
“Anyone who trades in markets where prices are continuously changing knows that participants are very much influenced by market developments. Rising prices often attract buyers and vice versa. How could self-reinforcing trends persist if supply and demand curves were independent of market prices?”
“The theory of perfect competition could be defended by arguing that the trends we can observe in commodity and financial markets are merely temporary aberrations which will be eliminated in the long run by the ‘fundamental’ forces of supply and demand…The trouble with the argument is that there can be no assurance that ‘fundamental’ forces will correct ‘speculative’ excesses. It is just as possible that speculation will alter the supposedly fundamental conditions of supply and demand.”
“If we want to understand the real world, we must divert our gaze from a hypothetical final outcome and concentrate our attention on the process of change that we can observe all around us. This will require a radical shift in our thinking. A process of change is much more difficult to understand than a static equilibrium. We shall have to revise many of our preconceived ideas about the kind of understanding that is attainable and satisfy ourselves with conclusions that are far less definite than those that economic theory sought to provide.”