What Is Negative Feedback?

Negative feedback occurs in a system when outputs are routed back as inputs to exacerbate some negative outcome, making a bad situation increasingly worse, as with an economic panic or a deflationary spiral. Its opposite is positive feedback, in which a good outcome is perpetuated, or when herd mentality pushes elevated prices ever higher,

Negative feedback can alternatively be defined as a system where outputs mute or moderate the initial inputs, with a dampening effect. In the context of contrarian investment, 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, by this definition, helps make markets less volatile.

Key Takeaways

  • Negative feedback, or a negative feedback loop, is a self-perpetuating downward spiral where some initial bad event is compounded and made increasingly worse by the behaviors that result from that initial event.
  • During times of financial distress, a sense of panic and fear about the market can drive share prices lower and lower.
  • An investor using a negative feedback strategy would buy stocks when prices decline and sell stocks when prices rise.

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, negative events like stock price drops, bearish news headlines, social media rumors, and shocks snowball from a relatively minor initial event into an ever-compounding downward spiral. Financial panics and market crashes are examples of negative feedback in markets.

Warren Buffett is often quoted as saying the markets are frequently nonsensical as opposed to proponents of the Efficient Markets Hypothesis (EMH) which 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.

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 at the start of the year 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 environment of higher-than-normal supply in oil created a downward trend in oil prices. At that same time, several investing funds also began to more strongly incorporate Environmental, Social, and Governance (ESG) mandates into their investment selection policy.

This created an environment where many energy company stocks became less attractive to investment funds with those ESG mandates at the same time share prices were weakened by declining oil prices. A perfect storm then hit when 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 that time drove energy stocks lower at a frenetic pace as sector fund outflows accelerated. Lower prices inspired more investors to protect capital, which precipitated more selling, which inspired still others to do likewise. By the time the selling had reached its most intense moment during the pandemic, shares of the most heavily capitalized company in the sector, Exxon Mobil (XOM), was priced below the company's book value, a condition that hadn't occurred in that company's share price since the merger between Exxon and Mobil.

Exxon Mobile (XOM) Monthly Chart - Below Book Value
XOM share price dips below book value (PB ratio 1.00).

Special Considerations

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.

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 FAQs

What Is Negative and Positive Feedback?

Many believe financial markets exhibit feedback loop behavior. Positive feedback amplifies change, meaning as share prices increase, more people buy the stock, pushing prices further. Negative feedback minimizes change, meaning investors buy stocks when prices decline and sell stocks when prices rise.

What Is an Example of Negative Feedback?

One example of a negative feedback loop that occurs constantly is the body's method of maintaining its internal temperature. The body senses an internal change (such as a spike in temperature) and activates mechanisms that reverse, or negate, that change (the activation of the sweat glands).

What Is Meant by Negative Feedback Loop?

In the context of financial markets, a negative feedback loop refers to either behavior that compounds a bad outcome, or that minimizes change rather than amplifying it. In the latter case, investors buy stocks when prices decline and sell stocks when prices rise.