2009

©2012 Open Society Foundations. Some rights reserved. 400 West 59th Street | New York, NY 10019, U.S.A. | Tel 1-212-548-0600 | www.soros.org Transcript: General Theory of Reflexivity The following is a transcript of a lecture given by George Soros at Central European University on October 26, 2009. 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. I started developing my philosophy as a student at the London School of Economics in the late 1950s. I took my final exams one year early and I had a year to fill before I was qualified to receive my degree. I could choose my tutor and I chose Karl Popper, the Viennese-born philosopher whose book The Open Society and Its Enemies had made a profound impression on me. In his books Popper argued that the empirical truth cannot be known with absolute certainty. Even scientific laws can't be verified beyond a shadow of a doubt: they can only be falsified by testing. One failed test is enough to falsify, but no amount of conforming instances is sufficient to verify. Scientific laws are hypothetical in character and their truth remains subject to testing.

WESCO FINANCIAL CORPORATION LETTER TO SHAREHOLDERS To Our Shareholders: Consolidated net “operating” income (i.e., before realized investment gains shown in the table below) for the calendar year 2009 decreased to $54,073,000 ($7.59 per share) from $77,562,000 ($10.89 per share) in the previous year. Consolidated net income decreased to $54,073,000 ($7.59 per share) from $82,116,000 ($11.53 per share) in 2008. The 2008 figure included realized after-tax investment gains of $4,554,000 ($.64 per share). No investment gains or losses were realized in 2009. Wesco has four major subsidiaries: (1) Wesco-Financial Insurance Company (“Wes- FIC”), headquartered in Omaha and engaged principally in the reinsurance business, (2) The Kansas Bankers Surety Company (“Kansas Bankers”), owned by Wes-FIC and specializing in insurance products tailored to Midwestern community banks, (3) CORT Business Services Corporation (“CORT”), headquartered in Fairfax, Virginia and engaged principally in the furniture rental business, and (4) Precision Steel Warehouse, Inc. (“Precision Steel”), head- quartered in Chicago and engaged in the steel warehousing and specialty metal products businesses. Consolidated net income for the two years just ended breaks down as follows (in thousands except for per-share amounts)(1) : Amount Per Wesco Share(2) Amount Per Wesco Share (2) December 31, 2009 December 31, 2008 Year Ended Wesco-Financial and Kansas Bankers insurance businesses — Underwriting gain (loss) . . . .

Buffett described the BNSF acquisition as a bet on the long-term future of American rail freight and, more broadly, on the American economy. He argued that rail's fuel efficiency relative to trucking, its durable right-of-way, and the capital intensity that protected it from new entrants made it an attractive long-horizon asset, and that owning it outright allowed Berkshire to redeploy the cash flows it generated rather than merely collect a dividend.

On the rationale for the BNSF acquisition.

Klarman's 2008 letter catalogues twenty lessons from the financial crisis that he argued investors had failed to learn. His central observation was that an entire generation of market participants had come to believe that central-bank action and innovation in financial engineering had eliminated the possibility of system-wide loss. He saw that belief, not the housing market itself, as the precondition for the eventual collapse. He argued that the mania had been built on layer upon layer of low-quality credit, each tranche of which had been rated by agencies paid by issuers, insured by counterparties whose own balance sheets were impaired, and bought by investors who had not read the offering documents. The complexity was not accidental - it concealed the absence of true underwriting. Each link in the chain assumed someone else had done the diligence. The lesson Klarman drew was that the absence of recent losses breeds the conditions for the next loss. He warned that even after 2008, the structural response - bailouts, quantitative easing, fiscal stimulus - would teach market participants that downside had been socialized. That expectation would, in turn, set up the next episode of moral hazard. He treated the post-crisis regime as the soil in which the next bubble would grow, not as a guarantee that bubbles could no longer occur.

The SEC and Indian regulators later documented that the inflated cash was concealed through a network of related-party transactions and forged bank statements, a structure that survived repeated audit cycles, raising durable questions about the audit firm's reliance on confirmation procedures.

The group's account frames the Satyam bid as an act of conviction pricing in the integration and governance risk that other bidders declined to take, and notes that the timing preserved the acquired firm's client relationships at a moment when client flight was the central risk.

Buffett opened the 2009 annual meeting against the backdrop of the recently completed crisis-era preferred equity investments in Goldman Sachs, General Electric, Wrigley and Harley-Davidson, totalling approximately $14.5 billion of crisis-deployed capital. Buffett and Munger told shareholders that the transactions had been structured to provide Berkshire with attractive current yield on the preferred and the warrants to acquire common equity at the strike prices, and that the underlying counterparty companies were positioned to weather the cycle given the durability of their underlying franchises. Buffett walked shareholders through the Berkshire capital deployment discipline during the crisis, framing the transactions as the natural outcome of carrying the largest cash position in Berkshire's history into the downturn. He flagged that the cash had been deliberately preserved for exactly the environment in which it had been deployed, that the warrants were the optionality on the long-term recovery of the underlying franchises and that Berkshire had been able to negotiate terms that no other counterparty could have negotiated because of the size of the cash deployment, the speed of execution and the perceived long-term stewardship that Berkshire provided to the counterparty companies. On the Q&A, shareholders pressed on whether the credit crisis implied that Berkshire's own insurance subsidiaries, especially the derivative structures Berkshire had entered into, were exposed to collateral calls. Buffett responded that the equity-indexed put and the credit default swap portfolios were long-dated and that the mark-to-market losses were not realisation events, that Berkshire's balance sheet had been stress-tested through significantly worse environments than the 2008 panic and that the Company would not be a forced seller of any position. Munger added that the most important lesson of the crisis was the rarity of being able to deploy large amounts of capital at attractive terms and that Berkshire had been preparing for exactly that environment for two decades. The meeting closed with Buffett and Munger reiterating the long-term framework of compounding intrinsic value per share, anchored on the insurance float, the wholly-owned operating businesses, the concentrated long-term equity portfolio and the willingness to carry large cash reserves through bull markets to deploy through panics.

On July 15, 1903, the newly formed Ford Motor Company took its first order, from Chicago dentist Ernst Pfenning, for an eight-hundred-and-fifty-dollar two-cylinder Model A automobile with a tonneau backseat, produced at Ford's plant on Mack Avenue in Detroit and delivered a little over a week later. The History.com account records that the order came after Henry Ford had built his first gasoline-powered vehicle, the Quadricycle, in a workshop behind his home in 1896 while serving as chief engineer at the Edison Illuminating Company, and after two unsuccessful prior attempts to start a company to manufacture automobiles. The first order signaled that the third attempt, the Ford Motor Company, would be the durable one. Within five years the company would introduce the Model T; within twenty, the moving assembly line, the five-dollar day, and the Rouge complex would together define modern mass-production capitalism.

A July 2007 New York Times study, adjusting for inflation, placed Vanderbilt behind only John D. Rockefeller among the wealthiest individuals in American history, and when he died in 1877 he left an estate of roughly one hundred million dollars. His biographer T. J. Stiles cautions that such comparisons are notoriously inexact and proposes a starker metric: total net worth as a share of money in circulation. In 1877 the United States circulated about nine hundred million dollars, meaning Vanderbilt held about one-ninth of the nation's currency. Measured the same way against the Federal Reserve's M2 money supply, Bill Gates's fifty-seven billion dollars represented roughly one one-hundred-thirty-eighth. By the share-of-currency standard the Commodore towers over every modern fortune. He earned it in the nineteenth century's transportation revolution: born into a world of sail and horse-drawn freight, he died in one of coal, steam, and iron rails.

Forbes' 2009 retrospective on Lynch's Magellan tenure catalogued more than a hundred 'ten-baggers' — stocks that had multiplied ten-fold from initial purchase — across his thirteen-year record. The list included Fannie Mae, Ford, Philip Morris, General Electric, and a long roster of consumer and industrial names whose underlying businesses compounded earnings at double-digit rates for years while their multiples expanded. Lynch's point in the article was that the ten-bagger is not a lottery ticket; it is the predictable result of owning a business whose earnings grow at twenty percent a year for fifteen years while the market slowly re-rates the multiple upward. The arithmetic of the ten-bagger is unromantic. A company that grows earnings at twenty percent a year for thirteen years has grown earnings by a factor of eleven. If the market eventually assigns a similar multiple to eleven-times-the-original earnings, the share price has gone up ten-fold. Lynch's edge was not in forecasting which company would be the next ten-bagger; it was in identifying companies with the durable growth runway to compound earnings at twenty percent for over a decade. The multiple expansion is the bonus; the earnings compounding is the engine. Lynch's honesty in the article about the misses alongside the hits is the part most retellings omit. For every ten-bagger in the Magellan record there were several zero-baggers — stocks that went to zero or close to it. The portfolio outperformed not because Lynch was right more often than the index, but because his winners were much larger than his losers. The asymmetric structure of equity returns — losses capped at one times the cost, gains uncapped — is what makes the ten-bagger discipline work. The investor who lets the winners run and cuts the losers short will, over a portfolio of fifty picks, produce a Magellan-like record even with a hit rate below fifty percent.

TED2009 featured Nilekani shortly before his government pivot, framing him as the visionary co-founder of outsourcing pioneer Infosys who would help determine whether India could sustain its then-breakneck progress. The TED platform itself legitimated him as a global public intellectual, not just an Indian CEO.

Vanderbilt's career centered on New York City and ran impossibly long: he remained in charge of his companies until 1876, at eighty-two. It began on the Hudson River, where he operated a passenger ferry, and he made his first serious money in the War of 1812, commanding a small vessel that helped break the British naval blockade of New York. He invested in the passenger railways of the 1830s, kept building steamships, and became a major player in the race to move hundreds of thousands of people from the Atlantic to the Pacific during the California gold rush. He involved himself deeply in the failed effort to dig a canal across Nicaragua in the 1850s and fought the American filibuster William Walker, who nearly seized Nicaragua as a private fiefdom. A consummately practical man, he read the pace of technological change better than anyone, and in 1864 sold his last steamship interests for railroads.

The Forbes article dwelt on the Fannie Mae position as Lynch's single largest contributor to Magellan's outperformance. Lynch began buying the mortgage agency in the early 1980s when its government-sponsored-enterprise status was widely assumed to be a liability rather than an asset. The market worried that Congress would tighten the agency's mortgage-purchase mandate, cap its retained-portfolio growth, or impose affordability requirements that would compress margins. Lynch read the actual legislation and concluded that the political risk was overstated; the agency's role in intermediating conforming mortgages was, in practice, indispensable to the U.S. housing finance system. The operational thesis was that Fannie Mae's spread between the yield on its retained mortgage portfolio and its cost of debt funding was structurally wider than the market credited. As the agency scaled its retained portfolio, the dollar amount of that spread grew faster than the share count, producing book-value-per-share growth at mid-to-high teens rates for years. Lynch added to the position through the 1980s as the thesis confirmed, and held through the 1987 crash and the 1990 recession. The position eventually became the single largest contributor to Magellan's total return over Lynch's tenure. Lynch's retrospective on Fannie Mae emphasised the importance of reading primary documents rather than analyst summaries. The political risk that the sell-side cited as a reason to avoid the stock was visible, on close reading of the actual statute, to be more limited than the headlines suggested. The investor who read the legislation and the agency's annual report could form an independent view of the regulatory perimeter, and that view was materially different from the consensus view reflected in the share price. The gap between those two views was the source of the ten-bagger return.

A second cluster of lessons in the 2008 letter concerns liquidity. Klarman observed that during the boom, investors systematically priced securities as if they would remain liquid under all conditions. They treated the ability to sell as a property of the asset rather than a function of market conditions, and were shocked when buyers disappeared. He framed this as a permanent feature of credit cycles rather than an anomaly of the housing era. Whenever leverage extends, the assets most dependent on rolling financing become illiquid at the first sign of stress. The lesson he drew was that an investor who depends on selling to exit a position is exposed to the moods of the market at the worst possible moment. The operational consequence is that Baupost treats liquidity as a one-way cost: illiquidity is only acceptable if the position's thesis does not depend on exiting at a marked price. The firm's preference for situations with a forced catalyst - a bankruptcy plan, a workout, a tender - follows from this. Rather than holding securities whose value depends on the market bid returning, the firm prefers to own securities whose value will be realized through a contractual process regardless of the bid.

Buffett wrote that the test for a large acquisition was whether it would increase Berkshire's per-share intrinsic value, and that the test had to be applied against the alternative of buying back Berkshire's own shares or returning capital to owners. He argued that the discipline of comparing every use of capital against the intrinsic-value-per-share benchmark was the chief defense against the temptation to do deals for their own sake.

On the per-share intrinsic-value test for acquisitions.

. . . . . . . . . . . . . . . . . . . . . . . $ 7,222 $1.01 $ (2,942) $ (.42) Investment income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55,781 7.83 64,274 9.03 CORT furniture rental business . . . . . . . . . . . . . . . . . . . . . . . . (1,359) (.19) 15,744 2.21 Precision Steel businesses . . . . . . . . . . . . . . . . . . . . . . . . . . . . (648) (.09) 842 .12 All other “normal” net operating earnings (loss)(3) . . . . . . . . . . (6,923) (.97) (356) (.05) 54,073 7.59 77,562 10.89 Realized investment gains . . . . . . . . . . . . . . . . . . . . . . . . . . . . . — — 4,554 .64 Wesco consolidated net income . . . . . . . . . . . . . . . . . . . . . . . $54,073 $7.59 $82,116 $11.53 (1) All figures are net of income taxes. (2) Per-share data are based on 7,119,807 shares outstanding. Wesco has no dilutive capital stock equivalents. (3) Includes income from ownership of the Wesco headquarters office building, primarily leased to outside tenants, and interest and dividend income from cash equivalents and marketable securities owned outside the insurance subsidiaries, less interest and other corporate expenses, and, in 2009, a $6.2 million (after taxes) writedown of real estate held for sale. This supplementary breakdown of earnings differs somewhat from that used in audited financial statements which follow standard accounting convention. The foregoing supple- mentary breakdown is furnished because it is considered useful to shareholders.

Ideologies which claim to be in possession of the ultimate truth are making a false claim; therefore, they can be imposed on society only by force. This applies to Communism, Fascism and National Socialism alike. All these ideologies lead to repression. Popper proposed a more attractive form of social organization: an open society in which people are free to hold divergent opinions and the rule of law allows people with different views and interests to live together in peace. Having lived through both Nazi and Communist occupation here in Hungary I found the idea of an open society immensely attractive. While I was reading Popper I was also studying economic theory and I was struck by the contradiction between Popper's emphasis on imperfect understanding and the theory of perfect competition in economics which postulated perfect knowledge. This led me to start questioning the assumptions of economic theory. These were the two major theoretical inspirations of my philosophy. It is also deeply rooted in my personal history. The formative experience of my life was the German occupation of Hungary in 1944. I was not yet fourteen years old at the time, coming from a reasonably well-to-do middle class background, suddenly confronted with the prospect of being deported and killed just because I was Jewish. Fortunately my father was well prepared for this far-from-equilibrium experience. He had lived through the Russian Revolution and that was the formative experience of his life.

His TED talk, which has accumulated over a million plays, laid out four brands of ideas that he argued would decide India's trajectory. The four-fold framework foreshadows his later thinking on DPI: ideas evolve into ideology, then policy, then action — a sequencing that explains his later insistence on building the right identity infrastructure before designing welfare programmes.

The decision to rebrand and absorb Satyam into Tech Mahindra rather than run it as a separate house reflected a preference for consolidating the IT-services franchise under one operating brand, a structural choice that simplified the group's technology narrative.

Raju's eventual conviction and imprisonment, alongside senior finance executives, closed the case as a matter of individual liability while leaving open the structural question of how Indian promoter-led firms police their own reporting, a question the SEBI reforms of the early 2010s partially addressed.

TED introduced Nilekani as the author of Imagining India, which it described as a radical rethinking of one of the world's great economies. The book-plus-talk combination positioned him, months before he accepted the UIDAI brief, as a thinker with a coherent development thesis — a credential that likely smoothed his cabinet-rank appointment.

Klarman's 2008 lessons also include a sustained critique of modern risk management. He argued that value-at-risk and similar quantitative frameworks had confused measurable recent volatility with the risk of permanent loss. By defining risk as the standard deviation of recent returns, the industry had effectively asserted that whatever had not recently happened could not happen. He pointed out that this is precisely backwards. The events that ruin portfolios are, almost by definition, those that did not appear in the recent sample. A risk model calibrated on the prior decade's data is most useful when least needed - in calm markets - and most dangerous when most needed, because the regime change it cannot anticipate is precisely the regime in which it is asked to perform. The proper approach, in his view, is scenario analysis grounded in fundamental downside cases rather than statistical extrapolation of normal times. Baupost's risk process therefore asks what a position is worth if the worst plausible fundamental scenario occur, and treats that as the binding constraint. Volatility is treated as a feature, not a measure of risk; the only risk that matters is the one that prevents the investor from holding the position through the recovery - which is, structurally, leverage or liquidity mismatch rather than price fluctuation.

Until then he had been an ambitious young man. When the First World War broke out, he volunteered to serve in the Austro-Hungarian army. He was captured by the Russians and taken as a prisoner of war to Siberia. Being ambitious, he became the editor of a newspaper produced by the prisoners.It

Stiles credits Vanderbilt's personal intervention in 1869 with saving the United States from a major financial crisis. When a group of speculators attempted to corner the nation's gold supply, the Commodore freed up sufficient capital to keep the panic from escalating into a depression, and was hailed as a hero, the savior of Wall Street. His enterprises demonstrably benefited the nation: historians Edwin Burrows and Mike Wallace calculate that roughly two hundred businesses relocated to cluster around the freight terminal he built on Manhattan's Lower West Side, drawn there like a gigantic magnet. The only thing more remarkable than his recklessness, Stiles observes, was his success. Vanderbilt seized the foundering New York and Harlem Railroad and restored it to profit, bought out railroad after railroad as an early master of modern corporate tactics, and by his death controlled many of the most important railroads in North America.

Forbes asked Lynch to reflect on the role of patience in producing the ten-bagger returns, and his answer was that patience is a function of conviction rather than temperament. The investor who can sit through a fifty percent drawdown is not the investor with the highest pain tolerance; it is the investor with the deepest understanding of the underlying business. The investor who bought on a screen will sell at the bottom because the screen no longer ranks the stock favourably; the investor who bought after visiting the company and reading the filings will hold because the operating reality has not changed. Lynch's example was Taco Bell, where he sat through an eighty percent drawdown because his scuttlebutt confirmed that the unit economics were intact. He contrasted that with the stocks he had sold too soon — the fast growers whose price had risen to what he considered fair value, where he had trimmed or exited, only to watch the businesses compound for another decade. His admission was that selling winners too early had cost Magellan more than holding losers too long. The bias toward action that the professional manager inherits from the brokerage culture is, in the long run, more expensive than the bias toward inertia. The deeper lesson Lynch drew was that the ten-bagger is not the product of superior forecasting but of superior holding. The forecasting problem — which businesses will compound earnings at twenty percent for a decade — is solvable with primary research. The holding problem — sitting through the drawdowns and the multi-year periods of no price movement — is the one most investors fail. Lynch's own record suggested that the holding discipline accounted for more of his outperformance than the stock-picking skill, however counter-intuitive that may seem to the casual reader of his books.

principal property-casualty affiliates (“Swiss Re”). Under this agreement, which was enthu- siastically approved by Wesco’s Board of Directors, Wes-FIC assumed 2% of essentially all Swiss Re property-casualty risks incepting over the five-year period which began on January 1, 2008, on the same terms as NICO’s agreement with Swiss Re. Wes-FIC’s share of written and earned premiums under the contract were $294.1 million and $276.7 million for 2009 and $265.2 million and $183.2 million for 2008, representing very significant increases in Wes- FIC’s reinsurance activities. It is important to keep in mind that premiums assumed under the contract in each of the next three years could vary significantly depending on market conditions and opportunities. For several years, through yearend 2007, Wes-FIC’s principal reinsurance activity con- sisted only of its participation in several pools managed by a subsidiary of General Rein- surance Corporation (“Gen Re”), another insurance subsidiary of Berkshire Hathaway. The arrangement became effective in 2001 and has covered domestic hull, liability and workers’ compensation exposures relating to the aviation industry. For the past three years, Wes-FIC has reinsured 16.67% of the hull and liability pools and 5% of the workers’ compensation pool. Since mid-2009 Wes-FIC has also been reinsuring 25% of an international hull and liability pool.

Vanderbilt was a great capitalist but not a great philanthropist. He left most of his fortune to his children and under five percent of it to charity, though the two to three million dollars he did dedicate to giving exceeded that of anyone else in his generation. Around 1873 a Catholic priest returned ten dollars he had found belonging to the New York Central; Vanderbilt had the money booked to the railroad's accounts and sat silently until the priest left, remarking afterward that there was considerable good in religion after all. In 1863 he declined to contribute to a hospital for wounded soldiers, writing that he owed it to himself to keep his name aloof from public acts granted in association with legislative bodies. In 1869 Mark Twain publicly demanded that he do something that was not shameful; the New York Herald answered that his numerous, liberal charities bore the reticence of his business character.

©2012 Open Society Foundations. Some rights reserved. 400 West 59th Street | New York, NY 10019, U.S.A. | Tel 1-212-548-0600 | www.soros.org was handwritten and displayed on a plank and it was called The Plank. This made him so popular that he was elected the prisoners' representative. Then some soldiers escaped from a neighboring camp, and their prisoners' representative was shot in retaliation. My father, instead of waiting for the same thing to happen in his camp, organized a group and led a breakout. His plan was to build a raft and sail down to the ocean, but his knowledge of geography was deficient; he did not know that all the rivers in Siberia flow into the Arctic Sea. They drifted for several weeks before they realized that they were heading for the Arctic, and it took them several more months to make their way back to civilization across the taiga. In the meantime, the Russian Revolution broke out, and they became caught up in it. Only after a variety of adventures did my father manage to find his way back to Hungary; had he remained in the camp, he would have arrived home much sooner. My father came home a changed man. His experiences during the Russian Revolution profoundly affected him. He lost his ambition and wanted nothing more from life than to enjoy it. He imparted to his children values that were very different from those of the milieu in which we lived. He had no desire to amass wealth or become socially prominent.

Another subsidiary of Gen Re provides a portion of the upper-level reinsurance protection to these aviation risk pools on terms that could result in the Berkshire subsidiary having a different interest from that of Wes-FIC under certain conditions, e.g., in settling a large loss. Premium volume under these pools has approximated $35 million annually. It is the nature of even the finest property-casualty insurance businesses that in keeping their accounts they must estimate and deduct all future costs and losses from premiums already earned. Uncertainties inherent in this undertaking make financial statements more mere “best honest guesses” than is typically the case with accounts of non-insurance-writing corporations. And the reinsurance portion of the property-casualty insurance business, because it contains one or more extra links in the loss-reporting chain, usually creates more accounting uncertainty than the non-reinsurance portion. Wesco shareholders should remain aware of the inherent imperfections of Wes-FIC’s financial reporting, based as it is on forecasts of outcomes over many future years. Wes-FIC’s underwriting results have typically fluctuated from year to year, but have been satisfactory. When stated as a percentage, the sum of insurance losses, loss adjustment expenses and underwriting expenses, divided by premiums, gives the combined ratio. Wes- FIC’s combined ratios from reinsurance activities were 94.9% for 2009, 101.0% for 2008 and 93.

TED's own framing emphasised that Nilekani had helped move India into the age of IT — a corporate legacy claim that, by being placed alongside his ideas-for-India talk, established a continuity between his Infosys work and his imminent public-sector assignment.

The clearest statement of what the university gift meant came from Charles F. Deems, a Southern Methodist minister who testified at the 1878 trial over the will. Vanderbilt, Deems recalled, had said the idea dated to the Rebellion: he had spent a million dollars sending a warship against the South to show where he stood, and now wanted to give a million after the war as proof that Northerners stood ready to extend the olive branch. The two gifts bracketed the conflict, the steamship donation for the Union Navy and the endowment for a Southern university, as matched bookends of sectional reconciliation. His son William added two hundred thousand dollars, and the school opened with a six-hundred-thousand-dollar endowment, exceptionally privileged among universities of its era. The philanthropic line then faded with the family: at a 1973 university reunion of one hundred twenty Vanderbilt descendants, not one was a millionaire.

9% for 2007, much better than average for insurers. We try to create some underwriting gain as results are averaged out over many years. We expect this to become increasingly difficult. Float is the term for money we hold temporarily. Its major components are unpaid losses and unearned premiums, less premiums and reinsurance receivable, and deferred policy acquisition costs. As long as our insurance underwriting results are break-even or better, float costs us nothing. The new Swiss Re venture with NICO has significantly increased Wes-FIC’s float, from $76 million at the end of 2007, to $264 million at yearend 2009, thus providing additional opportunities for investment. We hope to see our float continue to increase, but we make no predictions. Kansas Bankers was purchased by Wes-FIC in 1996 for approximately $80 million in cash. Its tangible net worth now exceeds its acquisition price, and it has been a very satisfactory acquisition, reflecting the sound management of President Don Towle and his team.

On the contrary, he worked only as much as was necessary to make ends meet. I remember being sent to his main client to borrow some money before we went on a ski vacation; my father was grouchy for weeks afterwards because he had to work to pay it back. Although we were reasonably prosperous, we were not the typical bourgeois family, and we were proud of being different. In 1944, when the Germans occupied Hungary, my father immediately realized that these were not normal times and the normal rules didn't apply. He arranged false identities for his family and a number of other people. Those who could, paid; others he helped for free. Most of them survived. That was his finest hour. * * * Living with false identity turned out to be an exhilarating experience for me too. We were in mortal danger. People perished all around us, but we managed not only to survive but to help other people. We were on the side of the angels, and we triumphed against overwhelming odds. This made me feel very special. It was high adventure. I had a reliable guide in my father and came through unscathed. What more could a fourteen-year-old ask for? After the euphoric experience of escaping the Nazis, life in Hungary started to lose its luster during the Soviet occupation. I was looking for new challenges and with my father's help I found my way out of Hungary. When I was seventeen I became a student in London.

The talk was presented at an official TED conference in February 2009, just months before his July 2009 move to chair UIDAI. The timing was deliberate: it allowed him to publicly articulate his framework for India before taking on the operational brief to build Aadhaar, effectively turning the talk into a job-spec preview.

The TED framing — co-founder of an outsourcing pioneer explaining India's future — underscored the unusual dual credibility Nilekani carried: he could speak with authority on both private-sector scale and public-sector ambition. Few Indian founders have been able to occupy that intersection as credibly in the global conversation.

In my studies, my primary interest was to gain a better understanding of the strange world into which I had been born, but I have to confess, I also harbored some fantasies of becoming an important philosopher. I believed that I had gained insights that set me apart from other people. Living in London was a big letdown. I was without money, alone, and people were not interested in what I had to say. But I didn't abandon my philosophical ambitions even when circumstances forced me to make a living in more mundane pursuits.a

Kansas Bankers was chartered in 1909 to underwrite deposit insurance for Kansas banks. Its offices are in Topeka, Kansas. Over the years its service has continued to adapt to the changing needs of the banking industry. Today its customer base, consisting mostly of small- and medium-sized community banks, is spread throughout 29 mainly Midwestern states. Kansas Bankers offers policies for crime insurance, check kiting fraud indemnification, Internet banking catastrophe theft insurance, Internet banking privacy liability insurance, directors and officers liability, bank employment practices, and bank insurance agents professional errors and omissions indemnity. Last year we reported that events in the banking industry, including a number of bank failures, caused us to become less confident in the long-term profitability of Kansas Bankers’ long-established line of deposit guarantee bonds. These bonds insure specific customer bank deposits above Federal insurance limits. After sustaining a loss of $4.7 million, after taxes, from a bank failure in the latter half of 2008, Kansas Bankers discontinued writing deposit guarantee bonds, and in September 2008 it began to exit this line of insurance as rapidly as feasible. The aggregate face amount of outstanding deposit guarantee bonds has been reduced, from $9.7 billion, insuring 1,671 institutions at September 30, 2008, to $33 million, insuring 10 institutions, currently.

We believe that none of the banks whose deposits are currently insured are facing significant risk of failure. This decrease in exposure to loss, of course, has caused a sharp decline in Kansas Bankers’ insurance volume, inasmuch as premiums from guarantee bonds not only approx- imated half of Kansas Bankers’ written premiums for 2008, but also represented the entirety of the business it had conducted in almost half of the states in which it was licensed to write insurance in 2008. The insurance business is highly competitive, with lengthy periods during which competitors offer coverages at prices we do not consider adequate. Kansas Bankers is now licensed to sell insurance in 29 states, down from 39 states one year earlier, with plans soon to withdraw from 4 more. We expect that Kansas Bankers will ultimately expand its premium volume, at prices deemed satisfactory. When Wesco purchased Kansas Bankers, it had been ceding almost half of its premium volume to reinsurers. In 2009 it reinsured only about 1%. And, because it has also restruc- tured the layers of losses reinsured, it is now better protected from the downside risk of large losses. Effective in 2006, insurance subsidiaries of Berkshire Hathaway became KBS’s sole reinsurers. Previously, an unaffiliated reinsurer was also involved. The increased volume of business retained comes, of course, with increased irregularity in the income stream. Kansas Bankers’ combined ratios were 140.2% for 2009, 111.6% for 2008 and 55.

©2012 Open Society Foundations. Some rights reserved. 400 West 59th Street | New York, NY 10019, U.S.A. | Tel 1-212-548-0600 | www.soros.org number of false starts. Finally I ended up as an arbitrage trader in New York but in my free time I continued to work on my philosophy. That is how I came to write my first major essay, entitled "The Burden of Consciousness." It was an attempt to model Popper's framework of open and closed societies. It linked organic society with a traditional mode of thinking, closed society with a dogmatic mode and open society with a critical mode. What I could not properly resolve was the nature of the relationship between the mode of thinking and the actual state of affairs. That problem continued to preoccupy me and that is how I came to develop the concept of reflexivity-a concept I shall explore in greater detail a little later. It so happened that the concept of reflexivity provided me with a new way of looking at financial markets, a better way than the prevailing theory. This gave me an edge, first as a securities analyst and then as a hedge fund manager. I felt as if I were in possession of a major discovery that would enable me to fulfill my fantasy of becoming an important philosopher. At a certain moment when my business career ran into a roadblock I shifted gears and devoted all my energies to developing my philosophy. But I treasured my discovery so much that I could not part with it.

The choice to publish his TED talk before leaving Infosys, rather than after, gave Nilekani a public intellectual platform from which to launch his government role — a useful signal to bureaucrats, foreign governments and global philanthropies that his Aadhaar brief was backed by serious prior thinking, not improvised on appointment.

I felt that the concept of reflexivity needed to be explored in depth. As I delved deeper and deeper into the subject I got lost in the intricacies of my own constructions. One morning I could not understand what I had written the night before. At that point I decided to abandon my philosophical explorations and to focus on making money. It was only many years later, after a successful run as a hedge fund manager, that I returned to my philosophy. I published my first book, The Alchemy of Finance, in 1987. In that book I tried to explain the philosophical underpinnings of my approach to financial markets. The book attracted a certain amount of attention. It has been read by most people in the hedge fund industry and it is taught in business schools but the philosophical arguments did not make much of an impression. They were largely dismissed as the conceit of a man who has been successful in business and fancied himself as a philosopher. I myself came to doubt whether I was in possession of a major new insight. After all I was dealing with a subject that has been explored by philosophers since time immemorial. What grounds did I have for thinking that I had made a new discovery, especially as nobody else seemed to think so? Undoubtedly the conceptual framework was useful to me personally but it did not seem to be considered equally valuable by others. I had to accept their judgment.

1% for 2007. Kansas Bankers’ business activities require a base of operations supported by significant fixed operating costs which do not lend themselves to downsizing in proportion to the recent decline in premium volume. We continue to expect volatile but favorable long-term results from the now much smaller business remaining in Kansas Bankers. CORT Business Services Corporation (“CORT”) In February 2000, Wesco purchased CORT Business Services Corporation (“CORT”) for $386 million in cash. CORT is a very long-established company that is the country’s leader in rentals of high- quality furniture that lessees have no intention of buying. In the trade, people call CORT’s activity “rent-to-rent” to distinguish it from “lease-to-purchase” businesses that are, in essence, installment sellers of furniture.

I didn't give up my philosophical interests, but I came to regard them as a personal predilection. I continued to be guided by my conceptual framework both in my business and in my philanthropic activities-which came to assume an increasingly important role in my life-and each time I wrote a book I faithfully recited my arguments. This helped me to develop my conceptual framework, but I continued to consider myself a failed philosopher. Once I even gave a lecture with the title "A Failed Philosopher Tries Again." All this has changed as a result of the financial crisis of 2008. My conceptual framework enabled me both to anticipate the crisis and to deal with it when it finally struck.to

However, just as Enterprise, as a rent-to-rent auto lessor in short-term arrangements, must be skilled in selling used cars, CORT must be and is skilled in selling used furniture. CORT’s revenues totaled $380 million for calendar 2009, versus $410 million for calendar 2008. Of these amounts, furniture rental revenues were $312 million and $340 mil- lion, furniture sales revenues were $61 million and $62 million, and rental relocation revenues were $7 million and $8 million. CORT operated at an after-tax loss of $1.4 million for 2009 versus after-tax profits of $15.7 million for 2008 and $20.3 million for 2007. Headwinds from the “Great Recession” that began in 2008 have caused the shift from moderate profit to the small loss that occurred last year. CORT has made several “tuck-in” acquisitions since its purchase by Wesco; most recently, the residential furniture rental division of Aaron Rents, Inc., purchased late in 2008. Earlier in 2008, CORTexpanded its operations internationally, through the purchase of Roomservice Group, a small regional provider of rental furniture and relocation services in the United Kingdom, now doing business as CORT Business Services UK Ltd. Factoring out the effects of those acquisitions, CORT’s core revenues fell by almost 20% in 2009, reflecting the hammering caused by the severe economic recession. So far, CORT’s business has been melting away faster than CORT can fix it.

©2012 Open Society Foundations. Some rights reserved. 400 West 59th Street | New York, NY 10019, U.S.A. | Tel 1-212-548-0600 | www.soros.org explain and predict events better than most others. This has changed my own evaluation and that of many others. My philosophy is no longer a personal matter; it deserves to be taken seriously as a possible contribution to our understanding of reality. That is what has prompted me to give this series of lectures. * * * So here it goes. Today I shall explain the concepts of fallibility and reflexivity in general terms. Tomorrow I shall apply them to the financial markets and after that, to politics. That will also bring in the concept of open society. In the fourth lecture I shall explore the difference between market values and moral values, and in the fifth I shall offer some predictions and prescriptions for the present moment in history. * * * I can state the core idea in two relatively simple propositions. One is that in situations that have thinking participants, the participants' view of the world is always partial and distorted. That is the principle of fallibility. The other is that these distorted views can influence the situation to which they relate because false views lead to inappropriate actions. That is the principle of reflexivity. For instance, treating drug addicts as criminals creates criminal behavior. It misconstrues the problem and interferes with the proper treatment of addicts.

Shortly after its acquisition by Wesco, CORT started up a nation-wide apartment locator service, originally intended mainly to supplement CORT’s furniture rental business by providing apartment locator and ancillary services to relocating individuals. Paul Arnold, long CORT’s able CEO, and his management team, have devoted much effort in recent years, expanding CORT’s rental relocation services, and redirecting them toward the needs of businesses and government agencies who require a skilled and able partner to provide comprehensive and seamless relocation services for the temporary relocation of employees worldwide. These efforts had not yet gained traction when recession hit. CORT is now focusing its efforts more on cost containment than on expansion of services. Under Wesco’s ownership, CORT has continuously undertaken to improve its compet- itive position. With several websites, principally, www.cort.com and www.apartment- search.com, professionals in more than 80 domestic metropolitan markets, affiliates servicing more than 50 countries, almost twenty-one thousand apartment communities referring their tenants to CORT, many ancillary services, and its entrée to the business community as a Berkshire Hathaway company, CORT is better positioned than previously to benefit from an economic turnaround if it occurs in due course. Near term, we expect more of the difficult business conditions of the recent past, but we do not expect another operating loss at CORT in 2010.

As another example, declaring that government is bad tends to make for bad government. Both fallibility and reflexivity are sheer common sense. So when my critics say that I am merely stating the obvious, they are right-but only up to a point. What makes my propositions interesting is that their significance has not been generally appreciated. The concept of reflexivity, in particular, has been studiously avoided and even denied by economic theory. So my conceptual framework deserves to be taken seriously-not because it constitutes a new discovery but because something as commonsensical as reflexivity has been so studiously ignored. Recognizing reflexivity has been sacrificed to the vain pursuit of certainty in human affairs, most notably in economics, and yet, uncertainty is the key feature of human affairs. Economic theory is built on the concept of equilibrium, and that concept is in direct contradiction with the concept of reflexivity. As I shall show in the next lecture, the two concepts yield two entirely different interpretations of financial markets. The concept of fallibility is far less controversial. It is generally recognized that the complexity of the world in which we live exceeds our capacity to comprehend it. I have no great new insights to offer. The main source of difficulties is that participants are part of the situation they have to deal with.

Instead, we expect disappointing profits. More details with respect to CORTare contained throughout this annual report, to which your careful attention is directed. Precision Steel Warehouse, Inc. (“Precision Steel”) The businesses of Wesco’s Precision Steel subsidiary, headquartered in the outskirts of Chicago at Franklin Park, Illinois, were pounded by the “Great Recession,” exacerbating a long-term reduction in demand resulting from movement of manufacturing outside the United States. Revenues were $38.4 million for 2009 versus $60.9 million for 2008. Sales volume for 2009, in terms of pounds sold, declined by one-third and represented less than half the annual volume that Precision Steel had sold thirty years earlier, when it was acquired by Wesco.

Precision Steel operated at an after-tax loss of $0.6 million in 2009 versus an after-tax profit of $0.8 million in 2008. These figures reflect after-tax LIFO inventory accounting adjustments increasing after-tax income by $1.5 million for 2009 and decreasing after-tax income by $0.7 million for 2008. Had it not been for the LIFO accounting adjustments, Precision Steel would have reported an after-tax operating loss of $2.1 million for 2009 versus after-tax operating income of $1.5 million for 2008. Moreover, the $2.1 million pre-LIFO-effect loss last year would have been about $0.5 million greater without after-tax profits from a couple of Precision Steel’s small businesses that are different from conventional steel warehousing. We do not consider Precision Steel’s recent operating results to be a satisfactory investment outcome, particularly when one compares its recent performance with its after-tax operating earnings which averaged $2.3 million for the years 1998 through 2000. And, because of the ongoing recession, more difficulty for Precision Steel will surely lie ahead. Apart from the recessionary-caused weakness, the general and ongoing decline in Precision Steel’s physical volume is a serious reverse, not likely to disappear in some “bounce back” effect once the economy recovers. Terry Piper, who became Precision Steel’s President and Chief Executive Officer in 1999, has done an outstanding job in leading Precision Steel through very difficult years.

Confronted by a reality of extreme complexity we are obliged to resort to various methods of simplification-generalizations, dichotomies, metaphors, decision-rules, moral precepts, to mention just a few. These mental constructs take on an existence of their own, further complicating the situation.

But he has no magic wand with which to compensate for competitive losses among his best customers or from the weak economic conditions. He is redoubling his efforts to pare costs, which must be his response to conditions faced. Tag Ends from Savings and Loan Days All that now remains outside Wes-FIC but within Wesco as a consequence of Wesco’s former involvement with Mutual Savings, Wesco’s long-held savings and loan subsidiary, is a small real estate subsidiary, MS Property Company, that holds tag ends of appreciated real estate assets consisting mainly of the nine-story commercial office building in downtown Pasadena, where Wesco is headquartered. Adjacent to that building is a multi-story luxury condominium building which MS Property Company has recently built and is in process of marketing. For more information, if you want a very-high-end condominium, simply phone Chris Greco (626-585-6700). MS Property Company’s results of operations, immaterial versus Wesco’s present size, are included in the breakdown of earnings on page 1 within “other operating earnings.” Other Operating Earnings (Loss) Other operating earnings (loss), net of interest paid and general corporate expenses, amounted to ($6.9 million) in 2009 and ($0.4 million) in 2008. The 2009 figure includes a $6.2 million after-tax writedown of the book carrying value of a condominium building that was completed in the worst condominium market in decades.

©2012 Open Society Foundations. Some rights reserved. 400 West 59th Street | New York, NY 10019, U.S.A. | Tel 1-212-548-0600 | www.soros.org The structure of the brain is another source of distortions. Recent advances in brain science have begun to provide some insight into how the brain functions, and they have substantiated Hume's contention that reason is the slave of passion. The idea of a disembodied intellect or reason is a figment of our imagination. The brain is bombarded by millions of sensory impulses but consciousness can process only seven or eight subjects concurrently. The impulses need to be condensed, ordered and interpreted under immense time pressure, and mistakes and distortions can't be avoided. Brain science adds many new details to my original contention that our understanding of the world in which we live is inherently imperfect. * * * The concept of reflexivity needs a little more explication. It applies exclusively to situations that have thinking participants. The participants' thinking serves two functions. One is to understand the world in which we live; I call this the cognitive function. The other is to change the situation to our advantage. I call this the participating or manipulative function. The two functions connect thinking and reality in opposite directions. In the cognitive function, reality is supposed to determine the participants' views; the direction of causation is from the world to the mind.

Other components of the other operating loss in 2009 were (1) rents ($4.1 million gross) principally from Wesco’s Pasadena office property (leased almost entirely to outsiders, including Citibank as the ground floor tenant), and (2) interest and dividends from cash equivalents and marketable securities held outside the insurance subsidiaries, less (3) general corporate expenses plus expenses involv- ing tag-end real estate and real estate held for sale.

By contrast, in the manipulative function, the direction of causation is from the mind to the world, that is to say, the intentions of the participants have an effect on the world. When both functions operate at the same time they can interfere with each other. How? By depriving each function of the independent variable that would be needed to determine the value of the dependent variable. Because, when the independent variable of one function is the dependent variable of the other, neither function has a genuinely independent variable. This means that the cognitive function can't produce enough knowledge to serve as the basis of the participants' decisions. Similarly, the manipulative function can have an effect on the outcome, but can't determine it. In other words, the outcome is liable to diverge from the participants' intentions. There is bound to be some slippage between intentions and actions and further slippage between actions and outcomes. As a result, there is an element of uncertainty both in our understanding of reality and in the actual course of events. To understand the uncertainties associated with reflexivity, we need to probe a little further. If the cognitive function operated in isolation without any interference from the manipulative function it could produce knowledge. Knowledge is represented by true statements. A statement is true if it corresponds to the facts-that is what the correspondence theory of truth tells us.

Consolidated Balance Sheet and Related Discussion Wesco has unusual balance sheet strength, concentrated in security holdings of its insurance subsidiaries. These holdings, in turn, are concentrated in a few securities. Details can be found in Note 2 to the accompanying financial statements. Wesco carries its investments at fair value. As a result, unrealized appreciation or depreciation, after income tax effect, is included as a component of shareholders’ equity and net worth per share. Affected substantially by changes in market value of securities owned, Wesco’s yearend net worth per share has varied only slightly during recent tumultuous years. Figures are as follows: 2006 $337 2007 356 2008 334 2009 358 These results are not impressive. Moreover, if net worth per share had been computed at its low point in the recent stock market panic, stability implied by the foregoing figures would have been considerably lessened. We repeat our standard warning. Business and human quality in place at Wesco continues to be not nearly as good, all factors considered, as that in place at Berkshire Hathaway. Wesco is not an equally-good-but-smaller version of Berkshire Hathaway, better because its small size makes growth easier. Instead, each dollar of book value at Wesco continues plainly to provide much less intrinsic value than a similar dollar of book value at Berkshire Hathaway.

But if there is interference from the manipulative function, the facts no longer serve as an independent criterion by which the truth of a statement can be judged because the correspondence may have been brought about by the statement changing the facts. Consider the statement, "it is raining." That statement is true or false depending on whether it is, in fact, raining. Now consider the statement, "This is a revolutionary moment." That statement is reflexive, and its truth value depends on the impact it makes.

Moreover, the quality disparity in book value’s intrinsic merits has, in recent years, continued to widen in favor of Berkshire Hathaway. The Board of Directors recently increased Wesco’s regular dividend from 391 ⁄2 cents per share to 41 cents per share, payable March 4, 2010, to shareholders of record as of the close of business on February 4, 2010. Shareholders can thank Director Elizabeth Peters for the recommendation that Wesco increase its next and future dividends to ensure that share- holders are paid in even pennies. This annual report contains Form 10-K, a report filed with the Securities and Exchange Commission, and includes detailed information about Wesco and its subsidiaries, as well as audited financial statements bearing extensive footnotes. As usual, your careful attention is sought with respect to these items. Shareholders can access much Wesco information, including printed annual reports, earnings releases, SEC filings, and the websites of Wesco’s subsidiaries and parent, Berkshire Hathaway, from Wesco’s website: www.wescofinancial.com. Charles T.2010

©2012 Open Society Foundations. Some rights reserved. 400 West 59th Street | New York, NY 10019, U.S.A. | Tel 1-212-548-0600 | www.soros.org Reflexive statements have some affinity with the paradox of the liar, which is a self-referential statement. But while self-reference has been extensively analyzed, reflexivity has received much less attention. This is strange, because reflexivity has an impact on the real world, while self- reference is purely a linguistic phenomenon. In the real world, the participants' thinking finds expression not only in statements but also, of course, in various forms of action and behavior. That makes reflexivity a very broad phenomenon that typically takes the form of feedback loops. The participants' views influence the course of events, and the course of events influences the participants' views. The influence is continuous and circular; that is what turns it into a feedback loop. Reflexive feedback loops have not been rigorously analyzed and when I originally encountered them and tried to analyze them, I ran into various complications. The feedback loop is supposed to be a two-way connection between the participant's views and the actual course of events. But what about a two-way connection between the participants' views? And what about a solitary individual asking himself who he is and what he stands for and changing his behavior as a result of his reflections?

In trying to resolve these difficulties I got so lost among the categories I created that one morning I couldn't understand what I had written the night before. That's when I gave up philosophy and devoted my efforts to making money. To avoid that trap let me propose the following terminology. Let us distinguish between the objective and subjective aspects of reality. Thinking constitutes the subjective aspect, events the objective aspect. In other words, the subjective aspect covers what takes place in the minds of the participants, the objective aspect denotes what takes place in external reality. There is only one external reality but many different subjective views. Reflexivity can then connect any two or more aspects of reality, setting up two-way feedback loops between them. Exceptionally it may even occur with a single aspect of reality, as in the case of a solitary individual reflecting on his own identity. This may be described as "self-reflexivity." We may then distinguish between two broad categories: reflexive relationships which connect the subjective aspects and reflexive events which involve the objective aspect. Marriage is a reflexive relationship; the Crash of 2008 was a reflexive event. When reality has no subjective aspect, there can be no reflexivity. * * * Feedback loops can be either negative or positive. Negative feedback brings the participants' views and the actual situation closer together; positive feedback drives them further apart.

In other words, a negative feedback process is self-correcting. It can go on forever and if there are no significant changes in external reality, it may eventually lead to an equilibrium where the participants' views come to correspond to the actual state of affairs. That is what is supposed to happen in financial markets. So equilibrium, which is the central case in economics, turns out to be an extreme case of negative feedback, a limiting case in my conceptual framework. By contrast, a positive feedback process is self-reinforcing.the

©2012 Open Society Foundations. Some rights reserved. 400 West 59th Street | New York, NY 10019, U.S.A. | Tel 1-212-548-0600 | www.soros.org participants would have to recognize them as unrealistic. Nor can the iterative process occur without any change in the actual state of affairs, because it is in the nature of positive feedback that it reinforces whatever tendency prevails in the real world. Instead of equilibrium, we are faced with a dynamic disequilibrium or what may be described as far-from-equilibrium conditions. Usually in far-from-equilibrium situations the divergence between perceptions and reality leads to a climax which sets in motion a positive feedback process in the opposite direction. Such initially self-reinforcing but eventually self-defeating boom-bust processes or bubbles are characteristic of financial markets, but they can also be found in other spheres. There, I call them fertile fallacies-interpretations of reality that are distorted, yet produce results which reinforce the distortion. * * * I realize that this is all very abstract and difficult to follow. It would make it much easier if I gave some concrete examples. But you will have to bear with me. I want to make a different point and the fact that it is difficult to follow abstract arguments helps me make it. In dealing with subjects like reality or thinking or the relationship between the two, it's easy to get confused and formulate problems the wrong way.

So misinterpretations and misconceptions can play a very important role in human affairs. The recent financial crisis can be attributed to a mistaken interpretation of how financial markets work. I shall discuss that in the next lecture. In the third lecture, I shall discuss two fertile fallacies-the Enlightenment fallacy and the post-modern fallacy. These concrete examples will demonstrate how important misconceptions have been in the course of history. But for the rest of this lecture I shall stay at the lofty heights of abstractions. I contend that situations that have thinking participants have a different structure from natural phenomena. The difference lies in the role of thinking. In natural phenomena thinking plays no causal role and serves only a cognitive function. In human affairs thinking is part of the subject matter and serves both a cognitive and a manipulative function. The two functions can interfere with each other. The interference does not occur all the time-in everyday activities, like driving a car or painting a house, the two functions actually complement each other-but when it occurs, it introduces an element of uncertainty which is absent from natural phenomena. The uncertainty manifests itself in both functions: the participants' act on the basis of imperfect understanding and the results of their actions will not correspond to their expectations. That is a key feature of human affairs.

By contrast, in the case of natural phenomena, events unfold irrespective of the views held by the observers. The outside observer is engaged only in the cognitive function and the phenomena provide a reliable criterion by which the truth of the observers' theories can be judged. So the outside observer can obtain knowledge. Based on that knowledge, nature can be successfully manipulated. There is a natural separation between the cognitive and manipulative functions. Due to their separation, both functions can serve their purpose better than in the human sphere.

©2012 Open Society Foundations. Some rights reserved. 400 West 59th Street | New York, NY 10019, U.S.A. | Tel 1-212-548-0600 | www.soros.org At this point, I need to emphasize that reflexivity is not the only source of uncertainty in human affairs. Yes, reflexivity does introduce an element of uncertainty both into the participants views and the actual course of events, but other factors may also have the same effect. For instance, the fact that participants cannot know what the other participants know, is something quite different from reflexivity, yet it is a source of uncertainty in human affairs. The fact that different participants have different interests, some of which may be in conflict with each other, is another source of uncertainty. Moreover, each individual participant may be guided by a multiplicity of values which may not be self-consistent, as Isaiah Berlin pointed out. The uncertainties created by these factors are likely to be even more extensive than those generated by reflexivity. I shall lump them all together and speak of the human uncertainty principle, which is an even broader concept than reflexivity. The human uncertainty principle I am talking about is much more specific and stringent than the subjective skepticism that pervades Cartesian philosophy. It gives us objective reasons to believe that our perceptions and expectations are-or at least may be-wrong.

Although the primary impact of human uncertainty falls on the participants, it has far-reaching implications for the social sciences. I can explicate them best by invoking Karl Popper's theory of scientific method. It is a beautifully simple and elegant scheme. It consists of three elements and three operations. The three elements are scientific laws and the initial and final conditions to which those laws apply. The three operations are prediction, explanation, and testing. When the scientific laws are combined with the initial conditions, they provide predictions. When they are combined with the final conditions, they provide explanations. In this sense predictions and explanations are symmetrical and reversible. That leaves testing, where predictions derived from scientific laws are compared with the actual results. According to Popper, scientific laws are hypothetical in character; they cannot be verified, but they can be falsified by testing. The key to the success of scientific method is that it can test generalizations of universal validity with the help of singular observations. One failed test is sufficient to falsify a theory but no amount of confirming instances is sufficient to verify. This is a brilliant solution to the otherwise intractable problem: how can science be both empirical and rational?

According to Popper it is empirical because we test our theories by observing whether the predictions we derive from them are true, and it is rational because we use deductive logic in doing so. Popper dispenses with inductive logic and relies instead on testing. Generalizations that cannot be falsified, do not qualify as scientific. Popper emphasizes the central role that testing plays in scientific method and establishes a strong case for critical thinking by asserting that scientific laws are only provisionally valid and remain open to reexamination. Thus the three salient features of Popper's scheme are the symmetry between prediction and explanation, the asymmetry between verification and falsification and the central role of testing. Testing allows science to grow, improve and innovate. Popper's scheme works well for the study of natural phenomena but the human uncertainty principle throws a monkey wrench into the supreme simplicity and elegance of Popper's scheme.

©2012 Open Society Foundations. Some rights reserved. 400 West 59th Street | New York, NY 10019, U.S.A. | Tel 1-212-548-0600 | www.soros.org The symmetry between prediction and explanation is destroyed because of the element of uncertainty in predictions and the central role of testing is endangered. Should the initial and final conditions include or exclude the participant's thinking? The question is important because testing requires replicating those conditions. If the participants' thinking is included, it is difficult to observe what the initial and final conditions are, because the participants' views can only be inferred from their statements or actions. If it is excluded, the initial and final conditions do not constitute singular observations because the same objective conditions may be associated with very different views held by the participants. In either case, generalizations cannot be properly tested. These difficulties do not preclude social scientists from producing worthwhile generalizations, but they are unlikely to meet the requirements of Popper's scheme, nor can they match the predictive power of the laws of physics. Social scientists have found this conclusion hard to accept. Economists in particular suffer from what Sigmund Freud might call "physics envy."

There have been many attempts to eliminate the difficulties connected with the human uncertainty principle by inventing or postulating some kind of fixed relationship between the participants' thinking and the actual state of affairs. Karl Marx asserted that the ideological superstructure was determined by the material conditions of production and Freud maintained that people's behavior was determined by drives and complexes of which they were not even conscious. Both claimed scientific status for their theories although, as Popper pointed out, they cannot be falsified by testing. But by far the most impressive attempt has been mounted by economic theory. It started out by assuming perfect knowledge and when that assumption turned out to be untenable it went through ever increasing contortions to maintain the fiction of rational behavior. Economics ended up with the theory of rational expectations which maintains that there is a single optimum view of the future, that which corresponds to it, and eventually all the market participants will converge around that view. This postulate is absurd but it is needed in order to allow economic theory to model itself on Newtonian physics. Interestingly, both Karl Popper and Friedrich Hayek recognized, in their famous exchange in the pages of Economica, that the social sciences cannot produce results comparable to physics. Hayek inveighed against the mechanical and uncritical application of the quantitative methods of natural science.

He called it scientism. And Karl Popper wrote about "The Poverty of Historicism" where he argued that history is not determined by universally valid scientific laws. Nevertheless, Popper proclaimed what he called the "doctrine of the unity of method" by which he meant that both natural and social sciences should be judged by the same criteria. And Hayek, of course, became the apostle of the Chicago school of economics where market fundamentalism originated. But as I see it, the implication of the human uncertainty principle is that the subject matter of the natural and social sciences is fundamentally different; therefore they need to develop different methods and they have to be held to different standards.explain

©2012 Open Society Foundations. Some rights reserved. 400 West 59th Street | New York, NY 10019, U.S.A. | Tel 1-212-548-0600 | www.soros.org and predict historic events. I contend that the slavish imitation of natural science inevitably leads to the distortion of human and social phenomena. What is attainable in social science falls short of what is attainable in physics. I am somewhat troubled, however, about drawing too sharp a distinction between natural and social science. Such dichotomies are usually not found in reality; they are introduced by us, in our efforts to make some sense out of an otherwise confusing reality. Indeed while a sharp distinction between physics and social sciences seems justified, there are other sciences, such as biology and the study of animal societies that occupy intermediate positions. But I had to abandon my reservations and recognize a dichotomy between the natural and social sciences because the social sciences encounter a second difficulty from which the natural sciences are exempt. And that is that social theories are reflexive. Heisenberg's discovery of the uncertainty principle did not alter the behavior of quantum particles one iota, but social theories, whether Marxism, market fundamentalism or the theory of reflexivity, can affect the subject matter to which it refers. Scientific method is supposed to be devoted to the pursuit of truth.

Heisenberg's uncertainty principle does not interfere with that postulate but the reflexivity of social theories does. Why should social science confine itself to passively studying social phenomena when it can be used to actively change the state of affairs? As I remarked in The Alchemy of Finance, the alchemists made a mistake in trying to change the nature of base metals by incantation. Instead, they should have focused their attention on the financial markets where they could have succeeded. How could social science be protected against this interference? I propose a simple remedy: recognize a dichotomy between the natural and social sciences. This will ensure that social theories will be judged on their merits and not by a false analogy with natural science. I propose this as a convention for the protection of scientific method, not as a demotion or devaluation of social science. The convention sets no limits on what social science may be able to accomplish. On the contrary, by liberating social science from the slavish imitation of natural science and protecting it from being judged by the wrong standards, it should open up new vistas. It is in this spirit that I shall put forward my interpretation of financial markets tomorrow. I apologize for dwelling so long in the rarefied realm of abstractions. I promise to come down to earth in my next lecture.

Decision — Launched Akre Focus Fund. Context: Mutual-fund vehicle for the three-legged-stool strategy. Outcome (known): Ran 16 years as a mutual fund; commentaries quarterly.

Decision — Built the compounder book (Constellation Software, Moody’s, Mastercard-style). Context: Three-legged-stool case studies in quarterly commentaries — verify each name in commentary text before tagging. Outcome (known): Long-running compounder track record documented in fund commentary.