Most of us have daydreamed about making a billion dollars over the course of our working lives. George Soros managed it in just a single notorious day in 1992. The Hungarian-American investor and philanthropist is widely regarded as one of the most successful hedge fund managers in the world, and he’s got the bank statements to prove it. Business magazine Forbes estimates that Soros is worth more than $8 billion – and that’s after giving away more than $32 billion to worthy causes 😮
Soros was born in Budapest in 1930. After surviving the Nazi occupation of Hungary, he headed to the UK, studying philosophy at the London School of Economics under influential thinker Karl Popper – whose teachings, as we’ll see, shaped Soros’s approach to investing along with much of his broader worldview.
Like many a burned-out philosopher, Soros then embarked upon a career in investment banking, emigrating to the US in 1956. He subsequently spent time at several New York financial firms before launching his own hedge fund setup, Soros Fund Management, in 1969. The company’s flagship Quantum Fund became well known for its aggressive investment strategy and consistently high returns for its investors. Successful short-term speculations on global financial market movements made Soros himself a lot of money – and a formidable reputation 🧐
Soros began to step back from the day-to-day management of Quantum around the turn of the millennium, instead focusing his time and money on philanthropy. Inspired by Karl Popper’s belief in strong democracies as the best bulwark against totalitarianism, Soros had begun to establish the network now known as Open Society Foundations in the early 1980s. Today, this group’s billion-dollar annual budget funds grants to civil society groups all over the world, aimed at the promotion of tolerance, transparency, and free debate.
Although closed to outside investors since 2011, Soros’s Quantum hedge fund remains one of the most successful investment vehicles in the world. Over its four decades in existence, Quantum’s average annual return of 20% has produced over $40 billion worth of investment gains. So how did Soros do it? 🤔
Much has to do with Quantum’s “global macro” strategy – an approach it shares with Ray Dalio’s blockbuster hedge fund Bridgewater Associates. Global macro funds both invest in (“go long”) and bet against (a.k.a. “short”) a wide range of investments around the globe, the idea being to profit from broad economic and political trends. A global macro investor might take the view that the US economy will perform better than Europe’s. They’d then buy a basket of US stocks, short a basket of European ones, and perhaps short the euro versus the dollar for good measure.
Global macro funds enjoy more flexibility than other hedge fund strategies. For one thing, they can invest in anything from traditional stocks and bonds to complex commodity futures and arcane interest rate swaps. They also simultaneously operate across short, medium, and very long time horizons. A global macro fund manager’s investment edge comes from anticipating the effects of large-scale macroeconomic and political shifts – and successfully positioning their portfolio to profit accordingly 🔭
And arguably nobody’s done this better than George Soros. His signature move involved making billions of dollars’ worth of gains in a matter of days by correctly predicting big currency swings. The most famous example of this was Soros’s $10 billion bet against the British pound in 1992 – and the day which saw him help “break” the Bank of England…
The European Exchange Rate Mechanism (ERM) was set up in 1979 to reduce fluctuations in the values of European currencies prior to the introduction of the common currency eventually known as the euro. The ERM also helped harmonize member countries’ monetary policies: their central banks’ attempts to control the supply of money in the economy and thereby achieve certain growth and inflation targets 🤓
The UK joined the ERM in 1990. As part of the deal, Britain agreed to prevent its currency from moving more than 6% in either direction versus the Deutsche mark. Only problem was, inflation in Britain was much higher than in Germany. An economic boom in the country had tipped over into unsustainable growth, setting the scene for an economic bust. These factors meant investors were putting downward pressure on the British pound – but the British government and the Bank of England (at that time less independent than it is today) were compelled to step in should the currency’s value risk falling below its lower agreed band against the Deutsche mark.
In a classic case of global macro investing in action, Stanley Druckenmiller, Soros’s long-term investment partner at Quantum, took the view that the pound was overvalued. He began shorting the pound – that is, betting it would fall further – in the summer of 1992, and Quantum was soon joined by other currency speculators who saw the pound’s peg to the Deutsche mark as unsustainable. Their actions forced Britain to intervene to defend the currency’s value, both by buying it on the open market and raising interest rates in an attempt to make shorting more expensive. But these actions were hugely expensive for the government 😟
By 1992, the Quantum Fund had shorted around $1.5 billion worth of pounds. Realizing that the British government was having trouble keeping the currency propped up, Soros now increased that bet to a whopping $10 billion. On Wednesday September 16th, the inevitable happened. Realizing it could no longer afford to defend the pound, the UK announced its withdrawal from the ERM and return to a freely floating currency. The pound promptly fell 15% versus the Deutsche mark – delivering Soros’s Quantum Fund over $1.8 billion in investment profit.
There are some important lessons for investors in all this. First, when considering any trade, it’s important to assess the risk/reward ratio – the investment’s potential upside relative to the danger of failure. The more favorable this ratio, the more money you can reasonably invest. While his partner came up with the original idea of shorting the pound, Soros made the key decision to increase the position over 500%. He realized that either the pound would stay relatively stable – in which case Quantum would only lose a little money – or else the British government would abandon the ERM, in which case the bet would pay off big. It was thus a relatively low-risk, high-opportunity trade which Soros sized accordingly 🤙
Another important takeaway is the existence of feedback loops in which investors' perceptions affect economic fundamentals – which in turn affect investor perceptions. In this case, investors saw the pound as overvalued and started shorting it. That caused a shift in economic fundamentals, with the British government raising interest rates in order to prop up the currency. That led investors to conclude that the British government was becoming desperate, and that its attempts to defend the pound were unsustainable. This idea of feedback loops is called “reflexivity” – and its application to financial markets was actually pioneered by Soros himself.
Reflexivity has its origins in social theory, where it referred to circular relationships between cause and effect. The concept was expanded to science in general by Karl Popper – Soros’s old philosophy professor in London. Soros in turn applied it to economics and finance, discussing this in depth in his 1987 book The Alchemy of Finance. The idea is that investors base decisions on their perceptions of reality rather than on reality itself. Their subsequent actions, however, do have an impact on realities such as economic fundamentals, which leads to a shift in investors' perceptions and thus investments’ prices. Soros credits much of his success to his understanding and application of reflexivity to financial markets 🔁
A bank run is a classic example of reflexivity in action. Let’s say customers of Bogus Bank believe, for whatever reason, that it’s in a weak financial position. They start withdrawing deposits in case the bank ends up unable to pay out. Even though Bogus is actually in a solid financial position, a large enough number of people pulling their money could push the bank into insolvency. The heightened fear of that happening prompts yet more withdrawals – until, in a self-fulfilling prophecy, Bogus Bank does indeed go bankrupt. This is an example of how perceptions can impact economic fundamentals.
Reflexivity can help explain the cycle of economic booms and busts. In fact, Soros used the theory to predict the 2008 financial crisis and Quantum was one of the few hedge funds that made money that year. The big issue with self-reinforcing feedback loops in investing is that market prices can become increasingly detached from economic reality. In the lead-up to 2008, would-be homeowners thought property prices would go up forever. Their purchases did in fact drive up real estate prices, which led to more mortgage lending by banks – fueling yet higher prices. Eventually, however, the bubble burst, forming one of the main causes of the crisis and resulting recession 😣
Now that you’ve got a better understanding of who George Soros is and some of the drivers behind his investment success, there are a couple of ways you can apply that information to improve your own investing 🤝
First, consider whether the global macro investment style resonates with you. If you like the idea of spotting large-scale trends and anticipating their impact, have a go at implementing a similar strategy, initially using a small portion of your portfolio. Finding investment ideas that should profit from such trends may not be as hard as you think – although don’t expect to make a billion overnight.
Second, before you make any investment, be sure to always assess the risk/reward ratio – its most likely outcomes, both positive and negative. The more favorable this ratio, the better the trade. And that takes us to our third lesson: the better an investment’s risk/reward ratio, the bigger you should size it.
Last but not least, try to use the concept of reflexivity to think about how investor perceptions can influence reality, in turn influencing those perceptions themselves. Being mindful of these feedback loops could help you realize when market prices are becoming too divorced from economic fundamentals – and that could present some interesting trading opportunities… 😉
🔹 George Soros is an investor and philanthropist, widely regarded as one of the most successful hedge fund managers in the world.
🔹 Soros’s Quantum Fund has made over $40 billion by successfully predicting large-scale macroeconomic and political trends.
🔹 One of Soros's most famous trades came good on Black Wednesday, when he made $1.8 billion betting against the British pound.
🔹 Soros credits much of his investment success to his understanding of reflexivity – the existence of self-reinforcing investor feedback loops that can also help explain economic booms and busts.
🔹 You can apply some of Soros's principles by focusing on major trends, assessing risk/reward ratios (and focusing on favorable ones), and using reflexivity to recognize when prices diverge too much from economic reality.
Now test your knowledge before putting it into practice: take our quiz.
/3 • Your free quarterly content is about to expire. Uncover the biggest trends and opportunities. Subscribe now for 50%. Cancel anytime.