Positive Feedback: What it is, How it Works

What Is Positive Feedback?

Positive feedback—also called a positive feedback loop—is a self-perpetuating pattern of investment behavior where the end result reinforces the initial act. For asset bubbles, positive feedback loops can propel the price of a security far above its fundamentals.

Positive feedback may be contrasted with negative feedback.

Understanding Positive Feedback

Positive feedback refers to a pattern of behavior in which a positive outcome generated from an initial act, such as executing a profitable trade, gives an investor the confidence to engage in other similar acts in the hopes that there will also be positive outcomes.

While these additional actions can also result in positive outcomes, these behaviors often lead to adverse outcomes if they are left unchecked. An investor that experiences an immediate gain after purchasing a stock may overestimate their own abilities in executing that stock trade and underestimate luck or ancillary market conditions. In the future, this could lead to overconfidence when making investment decisions.

Positive feedback, in the context of investing, often refers to the tendency of investors to exhibit herd mentality which can morph into irrational exuberance when buying or selling assets.

Herding Behavior

Herd mentality—which causes investors to sell when the market is declining and buy when it's rising—is an example of the aggregate effects of positive feedback. In other words, positive feedback is a key reason that market declines often lead to further market declines rather than returning to normal levels (and increases often lead to further increases).

For example, a rise in demand for a security causes the price of that security rise. This rise could spur investors to buy that security in the hopes that they can profit from the continuation of the increase in prices. This further escalates the demand for that security.

When a cycle of positive feedback continues for too long, investor enthusiasm can lead to irrational exuberance. Irrational exuberance can precipitate asset bubbles and eventually lead to a market crash.

Positive Feedback and Other Investor Biases

Confirmation bias is a common investor bias that's very similar to positive feedback. In these cases, investors pay more attention to information that supports their own opinions while ignoring conflicting opinions.

A great way for investors to avoid this bias is to seek out information that contradicts their investment thesis to widen their viewpoint. That way, they may realize that the market is involved in a positive feedback loop and make rational decisions about the investment or position size.

Another cognitive bias related to positive feedback is called trend-chasing. Despite hearing a warning with every investment opportunity, many investors mistakenly believe that past performance is indicative of future investment performance.

Investment products that may have benefited from a positive feedback loop may increase their advertising when past performance is high to take advantage of these biases; it's important for investors to take a step back and objectively look at likely future performance.

The best way to avoid these biases is by developing a rational trading plan and measuring its results over time. That way, investors can be confident that the system they have developed is performing as expected and avoid the temptation to attribute outcomes to external causes.

Frequently Asked Questions

How do positive feedback loops occur?

A positive feedback loop happens when the product of a reaction leads to an increase in that reaction. In investments, an increasing price can lead other investors to fear that they are missing out on something; so, they also invest, which bids the price even higher.

How is positive feedback related to behavioral finance?

Several findings in behavioral finance can lead to positive feedback loops in markets. Herd mentality and greed, for example, can cause individuals to jump on a bandwagon without having done their objective due diligence.

For example, during the dotcom bubble of the late 1990s, dozens of tech startups emerged that had no viable business plans, no products or services ready to bring to market, and in many cases, nothing more than a name (usually something tech-sounding with ".com" or ".net" as a suffix). Despite lacking in vision and scope, these companies attracted millions of investment dollars and saw sky-high stock prices. However, the bubble ultimately popped.

How do positive and negative feedback differ?

The opposite of positive feedback, a negative feedback loop occurs when the result of some action leads to less of it. In investing, negative feedback loops can cause prices to crash. For example, during flash crashes, algorithms processing micro-information on trading data all begin to pile in to sell simultaneously, triggering even more selling.