Turbulent markets (part 2): the role of feedback

As market turbulence continues, this post takes a look at the role played by feedback in complex systems such as investment markets.

Feedback drives natural systems

A couple of weeks ago, I noted that economies and investment markets are not machines, and don’t behave like them. One of the features that distinguishes complex systems from physical systems is the role played by feedback.

Consider the ant colony example¹ I mentioned in the previous post: If an ant colony is threatened, then a guard ant lays down a certain pheromone, which attracts other ants. When those ants become aware of the threat, they lay down more of that same pheromone. And so on until a whole army of ants has been mobilized to defend the colony. This mobilization is not the result of a central command hierarchy, but rather of a feedback loop reinforcing and compounding the individual actions.

Examples are all around us. A hurricane is the result of feedback in a weather system (the warmth creating more momentum, which in turn generates more warmth.) A blood clot is the result of feedback within the body.

These are examples of positive feedback, where the effect of a change reinforces the cause of the change. But there’s also negative feedback, where the effect serves to dampen the cause. For example, that’s how our bodies regulate our temperature (and lots of other things, too) or how predator/prey populations fluctuate together (more predators results in less prey results in fewer predators.)

When negative feedback is dominant, systems tend to run smoothly. It’s when positive feedback kicks in that things tend to become unstable.

Negative feedback in investment markets

The main form of negative feedback in markets is the pricing mechanism. When prices go up, markets are less attractively priced. That ought to make sellers more likely to sell and potential buyers less willing to buy. That in turn ought to push prices back down. And vice versa when prices fall.

So price movements ought to change the balance of supply and demand and should pull markets back to fair value, or to some average perception of fair value. And indeed they do, but only to some extent. If negative feedback were the only form of feedback loop that affected markets, we’d see a different type of market altogether than we do in practice. We’d see less trading than we really do see. We’d see much more stable prices. As George Akerlof and Robert Shiller put it in Animal Spirits: “Stock prices are much too variable… To pretend that stock prices reflect people’s use of information about those future payoffs is like hiring a weather forecaster who has gone berserk. He lives in a town where temperatures are fairly stable, but he predicts that one day they will be 150° and on another they will be–100°.”

Positive feedback, too

The fact that markets are so much more turbulent than a naïve analysis might suggest is largely down to the presence of positive feedback. Positive feedback can be the result, for example, of a herd instinct. This is how bubbles develop and it’s how crashes happen. From tulips to tech bubbles, each of financial history’s major bubbles and crashes is a story of decisions based not on value but on momentum, decisions driven by instinct, emotion, greed, fear. Each is a story of positive feedback in markets.

Set against the major market events of history, the fluctuations of the past few days and weeks have been nothing remarkable. They are continued evidence, though, that markets are complex systems, often fragile and unstable, an uneasy balance between negative and positive feedback.

¹For a much more complete description, see, for example, Complex Adaptive Systems: An Introduction to Computational Models of Social Life by John Miller and Scott Page (Princeton.)