Positive Feedback

Positive feedback, or a positive feedback loop, is a self-perpetuating pattern of behavior. In the context of investing, the term often refers to the tendency of investors to follow a herd mentality when buying or selling assets.

Positive feedback can refer to a pattern of behavior in which a positive outcome, such as executing a profitable trade, gives an investor the confidence to pursue further positive outcomes. While this can result in a positive outcome, these behaviors often lead to adverse outcomes if left unchecked. An investor that experiences an immediate gain after purchasing a stock may overestimate their own shrewdness in selecting the stock and underestimate luck or ancillary market conditions. In the future, this could lead to overconfidence when making investment decisions.

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.

The herd mentality that 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 and increases lead to further increases rather than returning to rational levels. When a cycle of positive feedback continues for too long, it can create an asset bubble that eventually leads to a market crash.

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 the trend-chasing bias. 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, so it's important for investors to take a step back and objectively look at likely future performance.