What Is Negative Feedback?
Negative feedback in financial markets comes from a pattern of contrarian investment behavior. An investor using a negative feedback strategy would buy stocks when prices decline and sell stocks when prices rise, which is the opposite of what most people do. Negative feedback helps make markets less volatile. Its opposite is positive feedback, in which a herd mentality pushes elevated prices higher and depressed prices lower.
How Negative Feedback Works
On an individual level, negative feedback can refer to a pattern of behavior in which a negative outcome, such as executing a losing trade, causes an investor to question his or her skill and discourages him or her from continuing to trade. Developing a rational trading plan and sticking to it can help investors maintain confidence and avoid falling into a negative feedback loop even when they execute a losing trade.
Many people believe financial markets can exhibit feedback loop behaviors. Originally developed as a theory to explain economics principles, the notion of feedback loops are now commonplace in other areas of finance, including behavioral finance and capital markets theory.
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 fuels more failure.
For example, a trader has a game plan to buy a stock after it crosses above the 50 day moving average, which the trader has determined to be a great entry point based on historical analysis. But, the trader begins trading and right off the bat realizes 4 losses in a row. These losses cause her to feel negative and she starts to second guess her strategy. After the losses hit, she then decides to do the opposite of her initial strategy, thus causing even greater losses. The takeaway here is that she should either quit trading for a bit and reassess or not give up due to a random string of poor performance.
Negative feedback 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. Negative 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.