Another example: the run on the financial markets. A run occurs when investors sell a stock solely because other investors are selling. A run can push a share price below the level called for by fundamentals such as earnings. This would not happen in a perfectly efficient market because investors would base their buy and sell decisions on the firm’s fundamentals. Once the price fell below the appropriate level, other investors would spot a bargain and buy, and that demand would cause the price to stabilize or rise, preventing a run. However, the feedback effect can give the run momentum by discouraging lenders from providing the firm with capital, weakening the company and spurring more selling.
Understanding the feedback process can also help firms fine-tune their capital-raising strategies, the authors write. A firm that wants to maximize feedback from the markets to guide decisions, for example, might choose to raise money by issuing stock rather than bonds. Bond prices are less sensitive to feedback because investors’ chief concern is the firm’s ability to make the interest and principal payments promised. As long as the firm is healthy enough to do that, factors like its earnings, the regulatory environment and business choices do not matter much to bondholders. But all those factors can influence stock prices, so stocks offer better feedback.
A considerable volume of research explores the theory of feedback, Goldstein said, and some examples are clear. “This kind of feedback loop serves to amplify shocks, and everyone saw that in the financial crisis,” he said.
But there’s much research still to be done, he added. Few financial models fully account for the effects of feedback. And although the theory of feedback effects seems solid, it is difficult to measure real-world results because so many factors cloud the data. A stock’s price can dip, for example, simply because a mutual fund has sold a large block of shares to meet investor redemptions, a price change that has nothing to do with information flowing through the market. If information were flowing at the same time, it would be very hard to know how much each factor had influenced the share price.
Future research should also look at how information from stock prices can be used more effectively by regulators, lenders, customers and others concerned with a firm’s health, Goldstein said. The study of feedback, he concluded, is only beginning. “I would say it’s been neglected for awhile, and it’s growing now.”
