Negative Feedback
Negative feedback describes a process in which a system’s outputs are routed back in a way that reduces, counteracts, or stabilizes the effects of the original input. In other words, it pushes a system toward equilibrium instead of amplifying change.
How it works in markets
In financial markets, negative feedback tends to dampen volatility. Typical mechanisms include:
Contrarian and value investors who buy after price declines and sell after rallies, countering extreme moves.
Arbitrageurs and spread traders who exploit mispricings created by emotional or herd-driven behavior, restoring price alignment with fundamentals.
These stabilizing responses serve to moderate sell-offs and rallies, reducing the chance that a small shock becomes a large-scale trend.
How it differs from positive feedback
- Negative feedback reduces deviation and encourages return to equilibrium.
- Positive feedback amplifies change: a small disturbance triggers self-reinforcing behavior that can snowball (e.g., bubbles or panics).
A common misuse of language is to call a self-perpetuating downward spiral a “negative feedback loop.” Technically, that is a positive feedback process—an initial bad event that is amplified by reactions, worsening the outcome.
Examples
- Investing: Dip buyers who step in during a market sell-off help stabilize prices instead of allowing the decline to accelerate.
- Biology: Human temperature regulation—if body temperature rises, sweating and increased blood flow cool the body, counteracting the rise.
Special considerations
- Feedback effects are most consequential during periods of market distress, when fear and herd behavior can make markets erratic.
- Negative feedback alone may not prevent large dislocations; prolonged positive feedback (panic selling or euphoric buying) can still lead to crises.
- Investors can help protect portfolios from damaging feedback loops by diversifying across assets and using strategies that identify and exploit extreme mispricings.
Key takeaways
- Negative feedback feeds a system’s outputs back in a way that diminishes or reverses the original change.
- In markets, it promotes stability; positive feedback, by contrast, amplifies trends and can create bubbles or crashes.
- Contrarian investors, arbitrageurs, and diversification are practical defenses against destabilizing feedback loops.
- The common colloquial use of “negative feedback loop” to mean a self-reinforcing bad outcome is technically incorrect; that’s an example of positive feedback.