Behavioral finance FAQ / Glossary (Feedback)

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Dates of related message(s) in the
Behavioral-Finance group (*):
Year/month, d: developed / discussed,
i: incidental

Feedback loop / positive feedback


 

00/6i,7i,8i,10i +- 01/11i - 02/4i,7i -
03/3i - 04/2i - 06/2i
+ see rational
expectations, cascade, (dynamical)
equilibrium, vicious / virtuous circle,
reflexivity + bfdef3

From a boomerang to a merry go round.


Definitions

A feedback (*) is any reaction / response in

a system to a signal, move, action,
information, change or event.

Behaviorists call "stimulus" what makes
people behave, like dogs that bark or even
bite
if you kick them.

This is obviously a generalization as people
have
more complex motivations. But they
also tend to react to information and signals
(see those words).
It is the theme of this article

A guy is
    punched in

the nose.

He strikes
back
.

 

 



 


As that response is also a signal, it creates 
    on its turn a reaction.

If it goes in the same direction (positive or
negative, see chapter below).
The process is a feedback loop (*).

The first
    puncher

strikes back
in its turn


It can be followed by another loop,

If it goes again in the same direction, positive
or negative. It becomes a feedback
spiral (*)
, that expands or retracts.

And so on,

until the whole
Dodge City
saloon gets
wild.

(*) Feedback is often used as a quasi synonym for feedback loop
     or spiral.

This Merry-Go-Round phenomenon is found as well in physical nature as in
human and social activities.

A feedback spiral happens for example in asset markets
* when price rises
trigger other price rises
* or price falls bring other price falls.

Positive and negative feedback loops

Adding to, or subtracting from the previous move.

That reaction to the event can happen in two opposite ways:

A positive feedback reinforces

or  amplifies the
event
(for example sustains /
accelerates a market trend)

A negative feedback reduces

or reverts

it (for example it reverts a market
trend).

It can even create a "reflexivity"
(see that word), a side event in
another area
that reinforces the
primary event.

A kind of shuttle is seen between
two fields (for example stock
price and corporate earnings).

It might even in some cases, over-
reach a reversion to the mean,

This leads to over-compensate
the initial event by moving
excessively  in the opposite
direction.


Such a positive or negative feedback can lead to another one.

We have then a positive or negative feedback loop .

This can go on an on, when a first amplifying / reducing reaction is
followed by a second, third, fourth, similar one, and so on,

Now we have a positive or negative feedback spiral .

Is a feedback an adaptive process?

Back to the old stability? Forward to a new stability?

Sideways into more disorder?

Better not expect too much stability!
And beware of vicious vortexes!


Feedback is sometimes considered as an adaptive / evolutionary process
(see evolutionary economics), by which a disequilibrium phase l
eads at the end to a phase of new "equilibrium" or at least to
some stability

But is that what really happens?

In the real world of dynamical systems (see that phrase),
full equilibriums do not really exist.

Even the appellation "dynamical equilibrium" is misleading, as things rarely
adjust exactly. Instability is part of their nature.

We can just say that there are periods when the situation seems
more stable, better balanced, more static (stasis phase), than in others.

Then the negative feedback takes over and bring self-regulating
oscillations
)

Thus we need to make here a difference between negative and
positive feedbacks.

A negative
    feedback
,

might go in the
direction of a
stabilization, and
subtracts from
(= reverts,
corrects) the
momentum.


This "correction" might entail a regression /
reversion to the mean,
a self-regulation, self-
stabilization.

It does not mean that a negative feedback
has always a favorable
"regulating" impact
in
the system,
as  there are cases in which:

Such a reaction, instead of stabilizing, spirals 
   too
far to the negative direction.

Or at least the negative reaction is a brake to 
    desirable evolutions.

A positive
    feedback

obviously does
not stabilize as 
it adds to
the
momentum, it

amplifies the 
event.

 

 


 



 

This nudge, at its start, might bring energy in the
right direction.

But the phenomenon can become cumulative.

Then it creates either a vicious - or a virtuous -
circle / loop / spiral.

  A vicious circle accentuates
     damages.

  A virtuous circle accentuates
    benefits,
    but in the end becomes excessive
    and brings  its own demise.

If we take stock markets as an example, as seen
below, a positive feedback might lead at the end
to excessively low or high stock prices.

Feedback in stock markets

Price rises feed price rises.

And price falls feed price falls.


Feedback loops / spirals happen in, among others fields, goods or asset
market prices

Stock markets are supposed to be self-corrective, as subjected to the law
of supply and demand like any market.

For example, when prices rise, people would buy less, which would
moderate the rise.

The reality is often different, as those markets are often prone to feedback
loops
based on investors' mimicry.

That phenomenon is sometimes rational (see cascade) and sometimes
irrational (see herding).

Those markets tend to show an alternation
     of cumulative positive and negative
     feedbacks loops / spirals on which

      trends are built.

 

When price rises trigger other price rises or price falls bring other

price falls, the market is caught in a typical positive feedback.

Thus it amplifies the market trend.
See information cascade.

Sometimes such a positive feedbacks even crosses the line
between financial market and economic fundamentals: see
reflexivity
.


In a negative feedback loop, stock prices seem to revert

to the mean (see reversion),

But  - when it is too strong or persistent and  overreach the mean -
it might become a positive feedback in the other direction.

=> In that case, prices do not stabilize around the mean.

On the contrary, they keep on moving and reach the other extreme.

This is how prices might run from extreme lows to extreme highs,

or the other way round (reversion to the extremes).


By the way, near stability (*) in asset prices also
   feeds itself,

(*) neutral or very slow moving trends, in parallel to economic and

monetary evolutions It gives the (possibly wrong) impression that
nothing will ever change, accelerate, decelerate or break.

Instead of a "normal" Gaussian distribution (see "distribution curve"),
the result takes another shape with fat tails / low kurtosis (see those
phrases), or a Pareto power law, or a log-normal law.

(*) To find those messages: reach that BF group and, once there,
      1) click "messages", 2) enter your query in "search archives".

Members of the Behavioral Finance Group,
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This page last update: 17/07/15  

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