What are feedback loops, and why should investors be aware of them?

Feedback loops can cause all sorts of issues, in the markets and elsewhere. In this article, Morgan Housel, best-selling author and partner at the Collaborative Fund, explores this concept.

I want to try to explain why Gamestop [GME] went up 100-fold in the last year and why Sears [SHLDQ] never recovered. They have to do with the same force in opposite directions. It’s a force that can explain a lot of baffling trends lately, and it’s so easy to underestimate and overlook.

First, a story about why some animals go extinct faster than people expect.

Forecasting when a species might go extinct is hard because whatever is causing a species to die off rarely progresses at the same rate. It can speed up in the blink of an eye in ways that surprise people.

Two researchers wrote a paper a few years ago explaining why.

Say an elephant is being hunted for its tusk. The rate of hunting often massively speeds up over time, cascading into a frenzy that pushes a mildly at-risk species into quick extinction.

It’s simple: As the number of elephants declines, tusks become rare. Rarity pushes prices up. High prices make hunters excited about how much money they can make if they find an elephant. So they work overtime. Then fewer elephants remain, tusk prices rise even more, more hunters catch on, they work triple-time, on and on until the number of hunters explodes as everyone chases the last herd of elephants whose super-rare tusks are suddenly worth a fortune.

"Rarity pushes prices up." - Morgan Housel

Forecasting models that don’t appreciate how frantic the last-minute hunt can become “give a false sense of security when managing large harvested populations,” the researchers wrote. A species’ endangerment starts slow, then picks up, gets a little faster, then boom … spirals into a disaster seemingly overnight. Supply and demand are intuitive; realizing how quickly supply and demand can go from linear to exponential is not.

Feedback loops — where one event fuels the next — often lead to that kind of bewilderment.

Find a feedback loop and you will find people who underestimate how crazy prices can get, how famous a person can become, how hard it can be to change people’s minds, how irreparable a reputation can be, and how tiny events can compound into something huge.

They take small trends and turn them into big trends with unforeseen momentum. And they happen in every field.

If you become a good reader as a child, reading is fun. When reading is fun you do it more. When you do it more you become a better reader — on and on. The opposite is true: delayed reading ability can make reading feel like work, which can cause kids to read less, which delays reading comprehension even more.

When it doesn’t rain, there’s less evaporation, which makes the air drier, which reduces rainfall, on and on.

And, of course, feedback loops can do astounding things in business and investing.

Sociologist Duncan Watts once wrote:

"[Common sense says] that when people make decisions about what they like, they do so independently of one another. But people almost never make decisions independently — in part because the world abounds with so many choices that we have little hope of ever finding what we want on our own; in part because we are never really sure what we want anyway; and in part because what we often want is not so much to experience the “best” of everything as it is to experience the same things as other people and thereby also experience the benefits of sharing."

"But people almost never make decisions independently" - Duncan Watts, sociologist

The idea that people like (or hate) what other people like (or hate) is important, because it lets small ideas grow bigger than you’d guess if you assume everything is ranked by quality alone. Social momentum is hard to model on a spreadsheet, so it’s hard to predict or think about in terms that seem rational. But it’s so powerful.

It can work wonders on the way up.

People want to shop at winning companies, and when people shop at a company it wins. A little momentum early on can grow into something enormous, well beyond what may have been predicted in the beginning. 

The same thing happens inside companies: Marc Andreessen says 80% of employee culture is just “winning.” The best employees want to work at companies that are winning, and when a company attracts the best employees it tends to win. If you don’t appreciate how powerful that feedback loop is you can be shocked at how dominant and wildly successful a few companies or products can become. Apple [AAPL], Amazon [AMZN], Tesla [TSLA] — they’re all enjoying the glorious feedback loop.

GameStop — which at the time of writing was up 100-fold in the last year as a reddit message board coordinates a buying spree to hurt short sellers — is experiencing a similar thing.

The reddit campaign to push up its stock started in November. At first shares rose a little. That caught people’s attention, those people bought, which pushed prices up more, which caught more people’s attention — on and on — until virtually every investor in America is paying attention to GameStop because it’s risen so high, and it’s rising high because every investor in America is paying attention to it. I have three friends who bought a few shares of GameStop “to see what happens.” They’re only doing that because the price went up.

"virtually every investor in America is paying attention to GameStop because it’s risen so high, and it’s rising high because every investor in America is paying attention" - Morgan Housel

And they’re making the price go up.

Attention is hard to obtain. But once it’s achieved it can take on a life of its own, becoming self-sustaining and able to morph into something you never imagined.

It works both ways.

General Motors [GM] had two options in 2008: Go bankrupt or convince the government to bail it out.

That started a debate over whether bankruptcy would cause a permanent downward spiral — even if GM kept making cars, consumers might not want to own a car sold by a bankrupt company. Fortune wrote:

"… the fear that car buyers won’t want to buy cars from a bankrupt automaker may preclude GM from financing. For example, a recent survey of car buyers found that as many as 80% wouldn’t even consider buying from a bankrupt automaker."

In the end, GM went bankrupt and was bailed out. But the idea that consumers would be embarrassed to buy from a bankrupt company, which would hurt GM’s sales, which would cause another bankruptcy, which would make consumers even more ashamed to own a GM car … on and on … shows that brands can change independent of a product’s quality. They get stuck in feedback loops that can be vicious — especially if you’re a household name and always in the news.

That’s part of what killed Sears.

Sears did a lot of things wrong. But the heaviest blow was getting stuck in a feedback loop where people don’t want to shop at Sears because it’s a failing company, and it’s a failing company because people don’t want to shop at Sears.

Once sales fall there’s less money to invest in stores. Then the stores get ragged, sales fall even more because it’s depressing to go inside a Sears that hasn’t been updated since the ‘90s, and investment falls even more. Then websites start writing stories about how ugly and dilapidated your stores are, then you wouldn’t be caught dead telling your friends “I’m going to Sears,” and the die is cast.

Once you look for feedback loops you see them everywhere. And once you realize how powerful they can be you start to answer some of the most frequent questions in business and investing.

"Once you look for feedback loops you see them everywhere" - Morgan Housel

How did prices get this high?

How did that company fall so hard?

How has this trend lasted so long?

Why is that company so dominant?

Why is the market so volatile?

Why is this person so famous?

Why is it so hard to break through?

The reason is usually small trends, once they get going, take on a life of their own, so things are usually crazier than you’d expect.

This article was originally written by Morgan Housel and published by Collaborative Fund on 28 January, here.