how negative feedback works
many people believe financial markets can exhibit feedback loop behaviors originally developed as a theory to explain economics principles the notion of feedback loops is now commonplace in other areas of finance including behavioral finance and capital markets theory with negative feedback events like stock price drops bearish news headlines social media rumors and shocks produce reactions that serve to stabilize or reverse that initial result dip buyers or profit taking sellers for instance can help minimize the severity of a selloff or rally this differs from positive feedback where input from a relatively minor initial event can snowball into an ever compounding downward spiral financial panics and market crashes are examples of positive feedback in markets that head in the negative direction bubbles are positive feedback loops that instead send prices higher warren buffett is often quoted as saying the markets are frequently nonsensical 1 this is in contrast to proponents of the efficient market hypothesis emh who would say that markets are always efficient consequently troubled stocks may be priced lower than a rational investor would anticipate simply because some investors are more panicked or pessimistic than most when this cycle persists the price can be driven below rational fundamental levels this can happen because of a negative feedback loop special considerationsfeedback within financial markets takes on significantly greater importance during periods of distress given humans propensity to overreact to greed and fear markets have a tendency to get erratic during moments of uncertainty the panic during sharp market corrections illustrates this point clearly such feedback even for benign issues becomes a negative self fulfilling cycle or loop that feeds on itself investors seeing others panic in turn panic themselves creating an environment that is difficult to reverse however many markets are restored to some sort of equilibrium through negative feedback arbitrage value investors and spread traders all seek to profit from mispricings generated by positive feedback loops by taking opposing positions to the emotional response one way investors can protect themselves from dangerous feedback loops is by diversifying their investments the negative self fulfilling cycles exhibited during the financial crisis of 2008 for example were very costly for millions of americans 