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The unstoppable force of feedback loops — Pop Economics

The unstoppable force of feedback loops

by Pop on November 30, 2010

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Working ourselves up into a frenzy.

Tell me if you recognize this story:

A group of developers begin building entire cities out of nowhere in Florida, putting hundreds of homes where none had existed and billing a “Florida lifestyle” of palm trees, relaxation, and tropical beaches.

As they snap up land, prices rise, and people begin to take vacations to Florida for the expressed purpose of getting in on the land rush. Some don’t even buy homes on the land. They’re content to live in tents.

As the buying continues, Realtors begin to outnumber builders. More buying and selling is going on than actual habitation.

And finally, the market runs out of new customers and the price of land starts to fall precipitously.

Sounds like 2007 and 2008, right? That was actually the great Florida land rush of the 1920s.

But it’s the same story with almost any bubble. At some point, people stop thinking about what the use of the investment is and start buying it based on the hope of rising prices alone.

Precipitating the acceleration of the bubble is our great social echo chamber.

Where the news comes from

Think of the most recent stock market headline you read. It probably didn’t focus too much on fundamentals, like the market’s dividend yield or P/E ratio. Instead it said something about price. Maybe something like “Dow falls below 11,000 for first time since August.”

You can’t really blame the media for it. They’re just telling you what happened, and the P/E is hard to explain when you’ve got 300 words to play around with.

But if you’re like most investors, that probably made you unhappy. Maybe a few thousand investors decided that it was time for them to “lock in their gains” and left the market the next day.

So tomorrow, you might read the headline “Market dips below 9,900 as investors seek safety.”

“Holy cow!” another thousand investors say, this is picking up momentum. A talking head or two on CNBC talks about tax fears or regulation or weak sales or something. Anything to add a rational explanation behind what’s going on, but in reality, nobody knows. Maybe it’s one of those things, but maybe it’s just that the price went down the previous day.

It’s not a phenomenon limited to stocks. There’s a story on CNN.com today about the feedback loop of depression and acne. People become depressed because they have acne, and on and on.

But in finance, you’ll most often hear about feedback loops in how investors tend to feed each other’s fears or euphoria, in a way that makes rational thinking head out the window.

How feedback loops disrupt “rational” markets

One theory of the financial crisis is that triple-A-rated mortgage-backed securities themselves (which were later found to be anything but triple-A) rose to prominence essentially through market feedback mechanisms.

Investors demanded more AAA-rated securities than the U.S. government and corporate world could provide, so banks created them out of the mortgage market. As investors snapped them up, they rose in price, which led to more being created, and so on.

One of the more amusing studies I stumbled across in researching this topic was by Matthieu Wyart and Jean-Phiippe Bouchaud. They posit that some of the common correlations that we see in today’s markets are self-reinforcing. Lately, markets have tended to see stock prices rise when bond prices fall, since investors must be eschewing “risky” stocks in favor of “safer” bonds. Go back a couple decades, and you would have seen stock and bond prices more commonly move in tandem. It’s our recent belief that they should move in opposite directions that makes it so.

So riddle me this: Is this historical P/E ratio of the market near 15 because that’s its natural place in a rational world? Or is it near 15 because we anticipate everyone else thinking it should be near 15 and bid stock prices up or down to reflect that?

If, over a short period of time, stock prices moved in tandem with sun spot activity, would we start to devise rational explanations as to why this might be the case and tie stock prices to sun spots even more closely? I’m being ridiculous of course, but humans do have a tendency to create “stories” to explain phenomena that might just be random.

Getting yourself out of the loop

Spoiler: I think it’s impossible.

Yeah, that’s right. For all my talk of value investing and my occasional forecasts, I have exactly zero dollars devoted to cashing in on any of the phenomena I think I’ve recognized. That’s pretty much because I think I’m just as caught up in the waves of euphoria and panic that plague us as everybody else.

I don’t think turning off the T.V. works. The news is everywhere. In 2000, your neighbor probably gave you stock picks at the local barbecue. In 2007, I don’t know how many friends tried to tell me I needed to buy a house. If you are reading this blog, you are in the feedback loop. I am the feedback loop. (Meta, I know.)

But the best solution I see to making sure the feedback loop doesn’t harm you is to restrict your ability to make decisions based on the loop. I don’t know how many times I’ve been tempted to open a trading account to buy the leveraged short Treasury bond ETF, which would make a lot of money if Treasury prices fall. I’m so sure this will happen.

Right now, though, I’d have to go through a 30-minute or so process to set up this account and transfer money to it, which is enough time to make me come to my senses.

Instead, all my money is in retirement accounts or mutual funds bought straight from Vanguard, which has a brokerage option that I don’t have set up. (I don’t think it’s set up. I’m afraid to look lest I discover it is.)

So the key, I think, is to be in the loop but have no power to act on the information you get from it.

Steps I’ve taken to save me from myself:

1. The aforementioned lack of a brokerage account.

2. I cripple my own confidence in my stock picking abilities. No seriously. I go out of my way to read hundreds of books and articles about how bad we are at making rational decisions. If that doesn’t lower your confidence level, I don’t know what will.

3. I have no dry powder (for investments). I have an emergency fund, and hopefully the temptation will never arise to use it for something other than an emergency. But other than that, I just don’t have a lot of cash to burn on a stock pick. So even if I did think I saw a great investing “opportunity”, there’s nothing I could do with the information.

I know this contrasts with advice you might have read elsewhere, maybe even here, but what good is dry powder when we’re so bad at putting it to use? I’d rather keep my money safe from myself in an index fund.

If you take anything away from this, I hope it’s that you can’t help being afraid or ebullient based on other people’s emotions. But that doesn’t mean those tendencies have to hurt you.

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{ 2 comments… read them below or add one }

Rob Bennett December 2, 2010 at 9:32 am

You can’t really blame the media for it. They’re just telling you what happened, and the P/E is hard to explain when you’ve got 300 words to play around with.

I blame the media but not only the media. I blame us all.

What you are describing is a cultural reality — the media doesn’t report on the danger of the feedback loop because few know of its dangers and thus it would take 300 words to describe them. If we all decided that having a functioning free market economy is worth taking whatever trouble it would take to educate people about the dangers of feedback loops, we could get about the business of doing that and from that point forward the point could be made in 10 words.

Our problem is that we have a defective investment advice culture. It is the humans who decide what their culture is going to be. We have the power here!

I do my part by pointing this sort of thing out as often as I can and in as strongly worded language as my feeble brain is capable of producing. We need more people doing that. A the losses resulting from our tolerance of a defective culture grow, we will get them. Then its over.

I can’t wait!

Rob

Steve January 4, 2011 at 10:41 am

the better article today is about the average stock “hold” increasing to 22 seconds from the 2007-2008 level of 20 seconds. Too many speculators with easy money, waiting to fleece your investment profits, within seconds of your investment. They are becoming thier own feedback loop because us “ma n pa’s” who had our retirement funds stolen from us in the recent market correction, are now only interested in GIC’s. Even if it makes no money, at least we are not losing money to the day traders. I am still insensed that you can buy stocks or mutual funds under a tax delayed rrsp, when you cant get the same protection for funds you take to the casino.

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