The theory of reflexivity has its roots in social science, but in the world of economics and finance, its primary proponent is George Soros. The post is not original and borrows heavily from George Soros's books, research paper and videos.
1. Fallibility and Reflexive System -
The cornerstone of this theory is that 'the complexity of the world we live in exceeds our capacity to comprehend it' - is called 'Fallibility'.
A reflexive system has thinking participants and the role of thinking participants are two-fold. 1. To understand objective reality - 'Cognitive Function' and 2. To take action after understanding objective reality - 'Manipulative Function'.
This theory is not specific to economics or finance, could be applied whenever a decision is made in the context of social science and an action is required or made.
Example 1. 'I love you' - This statement is reflexive. There is a cognitive function - 'I love this Person' because of x-y-z reasons; and there is a manipulative function - that is by saying 'I love you', the objective reality is changed. In other words, in this statement - love is both a noun and a verb.
Example 2. An investor says - 'I will buy/sell this stock after doing proper analysis'. One function of the investor is understanding objective reality (cognitive function) - through different types of analysis and another function is taking action (manipulative function). By buying/selling the stock, the objective reality is changed by the action of investor.
A perfect reflexive system would require two key assumptions - 1. There is no error in comprehending objective reality and 2. There is no error in taking action.
Both of the assumptions are broken most of the time in social science especially in Finance and Economics. This creates a classic boom-bust market cycle in financial markets.
In a simple example, let us assume that the investors use Earnings Per Share (EPS) to understand objective reality of the underlying stock. Due to fallibility and reflexivity, a classic boom-bust cycle emerges.
2. Social Phenomena vs Natural Phenomena -
For understanding objective reality, science uses the following framework to form a subjective theory. It works fine in a natural setting.
So in a natural phenomena, with time, our subjective theory will perfectly be able to capture the objective reality, using Popper's theory of falsification.
Due to fallibility, & human uncertainty, Popper's theory cannot properly assess objective reality in the social setting.
Risk and uncertainty could be broken down into 4 quadrants, to measure uncertainty of quadrant 2 is un-achievable and one of the main source of fallibility.
Due to that, the financial markets are never able to find the true equilibrium at a given point of time. There are temporary equilibrium but most of the time there are distortions, mispricing and significant risk and opportunities.
Conclusion - it's more complicated than you think.