What is negative feedback?
Negative feedback occurs in a system when outputs are returned as inputs to exacerbate some negative outcome, making a bad situation worse and worse, such as an economic panic or deflationary spiral. Its opposite is positive feedback, in which a good result is perpetuated, or when the herd mentality pushes higher and higher prices,
Negative feedback can alternatively be defined as a system in which the outputs mute or moderate the initial inputs, with a damping effect. In the context of reverse investing, an investor using a negative feedback strategy would buy stocks when prices drop and sell stocks when prices rise, which is the opposite of what most people do. Negative feedback, by this definition, helps make markets less volatile.
- Negative feedback, or a negative feedback loop, is a self-perpetuating downward spiral, in which some initial bad event is made worse and worse by the behaviors that result from that initial event.
- In times of financial distress, a sense of panic and fear over the market can drive stock prices lower and lower.
- An investor using a negative feedback strategy would buy stocks when prices drop and sell stocks when prices rise.
How negative feedback works
Many people believe that financial markets can exhibit feedback loop behavior. Originally developed as a theory to explain economic principles, the notion of feedback loops is now commonplace in other areas of finance, including behavioral finance and capital markets theory.
With negative comments, negative events such as stock price declines, bearish news headlines, rumors on social media, and a poignant snowball from a relatively minor initial event to an increasingly complicated downward spiral. Financial panics and market crashes are examples of negative feedback in the markets.
Warren Buffett is often quoted as saying that markets are often absurd compared to proponents of the Efficient Markets Hypothesis (EMH), who would say that markets are always efficient. Consequently, distressed stocks may be priced lower than a rational investor would anticipate simply because some investors are more scared or pessimistic than most. When this cycle persists, the price can fall below rational fundamental levels. This can happen due to a negative feedback loop.
Example of a negative feedback loop
A feedback loop is a term commonly used to describe how an output from a process is used as a new input to the same process. An example of a negative feedback loop would be a situation where failure and pessimism fuel more failure and more pessimism.
Consider the situation with oil prices and energy sector stocks in early 2020. The price of oil had been declining in the fourth quarter of 2019 as OPEC nations and Russia had little agreement on production limits . This resulting higher-than-normal oil supply environment created a downward trend in oil prices. At the same time, several investment funds also began to incorporate environmental, social and governance (ESG) mandates more strongly into their investment selection policy.
This created an environment in which many energy company stocks became less attractive to mutual funds with those ESG mandates at the same time as equity prices weakened from falling oil prices. Then there was a perfect storm as the COVID-19 pandemic precipitated travel restrictions and stay-at-home orders from governments around the world.
The general sense of panic among investors at the time sent energy stocks plummeting at a frantic pace as fund outflows from the sector accelerated. The lower prices inspired more investors to protect capital, which precipitated more sales, inspiring others to do the same. By the time the sale reached its peak during the pandemic, the shares of the industry’s most capitalized company, Exxon Mobil (XOM), were priced below the company’s book value, a condition that had not occurred at that company. . share price since the merger between Exxon and Mobil.
Negative feedback within financial markets takes on significantly more importance during times of trouble. Given the propensity of humans to overreact to greed and fear, markets tend to become erratic during times of uncertainty. The panic during the strong market corrections illustrates this point clearly. Negative feedback, even for benign problems, becomes a negative self-fulfilling cycle (or loop) that feeds on itself. Investors who see others panic, in turn, scare themselves, creating an environment that is difficult to reverse.
One way investors can protect themselves from dangerous negative feedback loops is by diversifying their investments. The negative self-fulfilling cycles exhibited during, say, the financial crisis of 2008 were very costly for millions of Americans.
Negative Feedback FAQ
What is negative and positive feedback?
Many believe that financial markets exhibit feedback loop behavior. Positive feedback amplifies change, which means that as stock prices rise, more people buy the stock, pushing prices even further. Negative feedback minimizes change, meaning that investors buy stocks when prices drop and sell stocks when prices rise.
What is an example of negative feedback?
An example of a negative feedback loop that occurs constantly is the body’s method of maintaining its internal temperature. The body detects an internal change (such as an increase in temperature) and activates mechanisms that reverse or negate that change (the activation of the sweat glands).
What is meant by a negative feedback loop?
In the context of financial markets, a negative feedback loop refers to behavior that exacerbates a poor result, or that minimizes change rather than amplify it. In the latter case, investors buy shares when prices fall and sell shares when prices rise.