“I’m only rich because I know when I’m wrong.” –George Soros
“One is inevitably going to be painfully wrong a lot, so knowing how to do that well is critical to one’s success.” –Ray Dalio
George Soros and Ray Dalio have many things in common. They are also polar opposites, borderline antagonists. Depending on how you look at it, both statements make sense. How did these two giants of finance manage to successfully navigate markets despite having diametrically opposed investment philosophies and strategies? Do philosophies and strategies not matter to success? Is there a magic process?
Both Soros and Dalio attribute their success as hedge fund managers to shaping a conceptual framework, as Soros calls it, or a set of principles, according to Dalio, not to some magic process.
In a 2009 lecture given at the Central European University, Soros says: “In the course of my life, I have developed a conceptual framework which has helped me both to make money as a hedge fund manager and to spend money as a policy-oriented philanthropist. But the framework itself is not about money; it is about the relationship between thinking and reality, a subject that has been extensively studied by philosophers from early on.”
In his book Principles, Dalio writes: “The most important thing I learned is an approach to life based on principles that helps me find out what’s true and what to do about it” He later adds: “Whatever success I’ve had is because of the principles I followed…”
In what follows, we explore the value of developing a worldview or a philosophy, and how it can translate into actionable strategies. Why is it important to build a philosophy, and in what way is it different from applying ready-made formulas or models that have already been tested and proven successful by others?
Beyond Formulas: The Role of Philosophy
A formula focuses on what to do. It consists of instructions or rules that apply within certain parameters and under specific circumstances. Such blueprints can be quite effective when we try to make sense of the environment and extract general rules. In the physical sciences mathematical rules usually operate within a broader model of reality, which includes various assumptions about the world, such as cause-and-effect relations, to help us understand motion and forces, among others.
In economics and finance formulas and models sometimes play a similar role. Valuation methods, risk measures, and other calculations rely on assumptions about cashflows, interest rates, investor behaviour to help inform decisions and understand sector dynamics.
Models and formulas in the natural sciences can, to a certain extent, be predictive. For example, we can calculate the position of planets within a small margin of error because they follow ‘objective’ physical laws.
However, standard tools in finance are far less predictive. Much of economic theory is predicated on certain assumptions about human action, such as the decision-making processes of individuals and firms. While many of these assumptions can be challenged, the theory nonetheless provides a useful framework to think about relationships: how outcomes can change when assumptions change. Finance theory is focussed on how decisions should be made, rather than how decisions are made by market participants.
“The only function of economic forecasting is to make astrology look respectable.” – Ezra Solomon
Because the financial world, and life in general, are influenced by uncertainty and by the decisions and reactions of other participants, relying solely on a fixed set of formulas is insufficient.
When a specific model or formula does not work in a particular situation, a broader conceptual framework, a philosophy, or a guiding lens, can serve as a more effective decision-making compass. This is what investors such as Soros and Dalio refer to when they speak of a ‘conceptual framework’ or ‘principles,’ respectively.
In that sense, a philosophy can be viewed as the foundation from which formulas can be derived. If a formula provides us with what to do, philosophical reflection is the process through which we form a lens, through which we think and interpret the world. Philosophy, in this sense, is more concerned with how to think.
In the absence of such a lens, we would be more prone to using strategies that don’t necessarily align with our goals and expectations. More critically, if we aren’t acting based on conviction, we would find it more difficult to interpret the broader climate, identify opportunities, or avoid following potentially risky trends.
Establishing a philosophy and putting it into action does not guarantee success. Both Soros and Dalio had a few mishaps along the road. Yet the very practice of thinking critically about the world gave them a clearer sense of the inherent uncertainty in which they operate. It also helped them recognise the limitations of their theories.
“I confess that I prefer true but imperfect knowledge, even if it leaves much indetermined and unpredictable, to a pretence of exact knowledge that is likely to be false.” –Friedrich von Hayek, The Pretence of Knowledge (Nobel Lecture, 1974)
The Soros Approach: Embracing the Feedback Loop
“My point is that there are occasions when the bias affects not only market prices but also the so-called fundamentals. This is when reflexivity becomes important.” –George Soros
In The Alchemy of Finance, Soros lays out and explains the theory of reflexivity, asserting that this concept gave him an edge compared to other fund managers and boosted his results. Simply put, the theory of reflexivity argues that when studying a phenomenon that includes a human observer, such as in the social sciences and economics, a reflexive or self-referential feedback loop is established between the event and how the human observers perceive and respond to it. For example, what people believe about the market can change the reality of the markets.
To illustrate this, Soros challenges the theory of equilibrium in economics, which assumes that prices in the long run tend to rest at an equilibrium point reflecting economic fundamentals. This, he points out, works only in theory, because it assumes that prices and economic fundamentals operate independently of human observers. However, market participants form expectations based on imperfect knowledge about future prices, and these expectations end up influencing the shape of future outcomes.
Soros does not claim that the markets are always governed by reflexivity, though. His main point is that most of the time, prices operate within parameters that don’t reflect major fluctuations in fundamentals. However, when sectors do end up behaving in a reflexive way, it is better for investors to acknowledge the uncertain element and act with a certain conviction, recognizing that there might be an opportunity to generate high returns. Soros does this by studying economic fundamentals, formulating hypotheses, and testing them by trial and error.
While this approach follows the scientific method of formulating hypotheses and testing them, Soros explains that the scientific method “seeks to understand things as they are,” while what he does is akin to alchemy, because finance aims for a “desired state of affairs.” While the scientific method aims for truth, the alchemy of finance aims for operational success.
At the core of Soros’ reflexivity theory is the idea of fallibility, or the awareness that his conceptual framework and decision-making can be wrong, despite often acting with high conviction. This allows him to constantly examine his assumptions, and change course when needed, without being subject to emotion-driven anxiety when things don’t go as he had originally intended.
The Dalio Approach: Decoding the Market Machine
“I learned my principles over a lifetime of making a lot of mistakes and spending a lot of time reflecting on them.” –Ray Dalio
Unlike Soros, Dalio’s philosophy is grounded in a mechanistic view of the world, governed by cause-and-effect relations. For him, everything in this world operates as a machine governed by a set of rules and laws, including nature, the economy, companies, plants, animals, and even humans.
His main premise is that because everything operates as a machine, if we can identify all the necessary inputs, coupled with the right assumptions and fundamental principles, we will be able to predict the direction of prices and other social and political aspects.
Take, for instance, the economy. To understand how this ‘machine’ works, according to Dalio, all we have to do is study history and past data to spot the patterns and basic laws that drive its different cycles. The economy, according to him, is governed by three major forces behind the various growth and contraction cycles. These three forces include productivity growth, the short-term debt cycle, and the long-term debt cycle.
Dalio’s outlook evolved over time, especially after he got a reality check in the early 1980s. During that time, he had publicly predicted that the US would face a severe debt crisis followed by an acute economic depression. He was so certain about this that he bet against the prevailing trend and ended up losing so much money that he had to borrow from his father to make ends meet.
The wake-up call was a humbling experience for Dalio and made him reassess his approach to investing and the way he understood the economy and the financial world. As he writes in Principles, “My painful mistakes shifted me from having a perspective of I know I’m right to having one of How do I know I’m right? They gave me the humility I needed to balance my audacity.”
From then on, Dalio crafted an All-Weather approach to investing based on broad diversification of the portfolio to account for all possible economic climates. His “holy grail” is selecting 15 uncorrelated return streams that would reduce his risk distribution while maintaining the rate of returns. In this way, he accounts for systemic uncertainty and the fact that his predictions about the market could be wrong.
The various elements that constitute Dalio’s philosophy, as reflected above, include a mechanistic view of the world, the belief that this understanding can be translated into a systematic decision-making framework, and an explicit recognition of human fallibility in the face of uncertainty. He explains, “There were only two big forces to worry about: growth and inflation. Each could either be rising or falling, so I saw that by finding four different investment strategies, each one of which would do well in a particular environment…”
Unlike Soros’ dynamic philosophy, Dalio’s machine-based framework drives him to pursue a deterministic decision-making system, aiming to be more rational, structured, and free from emotion. This view exposes Dalio to extreme cases of uncertainty, or reflexivity events, prompting him to adopt an aggressive diversification strategy to account for changes in the macro landscape.
From Philosophy to Practice: Finding What Works for You
“The future depends on ourselves, and we do not depend on any historical necessity.” –Karl Popper
As we saw, Soros and Dalio may hold widely divergent worldviews, yet they both managed to run their hedge funds successfully over the years. You might find yourself more inclined to agree with one or the other. What’s remarkable is that both attribute their accomplishments to their philosophies, which shape how they interpret markets and make decisions.
Often, when investors kick off their careers, they tend to import and focus on a selection of strategies and models that have a good track record, disregarding the importance of anchoring them to a conceptual framework or worldview.
During good market runs, these systems may seem to be working perfectly. When uncertainty hits, though, anxiety kicks in, and investors may find it difficult to understand what went wrong and how to navigate the situation gracefully.
“There are two kinds of forecasters: those who don’t know, and those who don’t know they don’t know.” – John Kenneth Galbraith
Cultivating a philosophical attitude and establishing a personal lens may seem like a theoretical exercise completely detached from reality. Even Soros admits this at some point in his book. However, by exploring different aspects of reality, thinking, and finance, it becomes easier for us to learn more about ourselves and think more clearly about the world. It helps us identify patterns, distinguish signal from noise, and construct portfolios that resonate better with our beliefs, goals, and risk tolerance.
In this way, we avoid the trap of jumping too late on trends or holding positions that would keep us up at night. This process requires an awareness of the principle of fallibility: namely, that our initial analysis and expectations may be mistaken.
The key is to develop a habit of introspection to examine our assumptions, study the world and the economy more critically, and engage in conversations that help us look at the world from different angles as we attempt to develop a more coherent and consistent stance.
As Dalio puts it: “While I will be sharing my own principles, I want to make clear to you that I don’t expect you to follow them blindly. On the contrary, I want you to question every word and pick and choose among these principles, so you come away with a mix that suits you.”
