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Mental Model Application - Feedback Loops

April 25, 2014
Grahamites

Grahamites

150 followers

"Systems of information - feedback control are fundamental to all life and human endeavor, from the slow pace of biological evolution to the launching of the latest space satellite……everything we do as individuals, as an industry, or as a society is done in the context of an information - feedback system. "

—Jay W.Forrester

The concept of feedback loops is not something new. George Soros (Trades, Portfolio)’s reflexivity is closely related to the feedback loops concept of system thinking mental model. I think this is a very powerful mental model and every investor should think about incorporate this mental model into his or her own investment process. My knowledge is largely derived from this wonderful book called “Thinking in Systems - A Primer” by Donella Meadows. Therefore, the theoretical part of this article is mostly based on Ms. Meadow’s book.

Essentially a feedback loop is formed “when changes in an element within the system affect the flows into and out of that same element. It is the consistent behavior pattern over a long period of time that is the first hint of the existence of a feedback loop.”

There are two types of feedback loops - reinforcing feedback loops and balancing feedback loops. Reinforcing feedback loops enhance whatever direction of change is imposed on a participants in the system and balancing feedback looks stabilize and regulate the extent of the direction of change. For example, the world’s population is subject to both reinforcing feedback loops and balancing feedback loops. If the birth rates pick up, more people will be born, which add to the population, which then further pushes up the birth rates. Of course people also die. Therefore, as long as the death rates are lower than the birth rates, the death rates will work as the balancing feedback loop to keep population growth in control.

Easy enough, right? You may ask, how are we supposed to apply this feedback loop concept to investing? Well, I think we can apply it in two general ways:

  1. Identify the feedback loops that are in play.
  2. Be cognizant of the shift of dominance of feedback loops.

Please allow me to illustrate my point using an example.

Let’s say you want to apply the feedback loop concept to an oil and gas E&P company. First of all, you have to identify both the reinforcing and balancing feedback loops. Keep in mind that there may be more one reinforcing or balancing feedback loops.

In this case, the reinforcing feedback loop work like this: Assuming the oil price allows the company to cover all expenses, as more oil is discovered, more profits can be made, which lead to more capital expenditure, which lead to more drilling, which then lead to further discovery of oil.

There are two balancing feedback loops: The first balancing feedback loop affects the equipments such as rigs by wearing them out. The second balancing feedback loop affects the oil reserve. As more oil is discovered, less oil is left underground and the more difficult it is to extract oil.

As long as the reinforcing feedback loop dominates the system, the company will keep making more money. But when the dominating feedback loops shift to the balancing feedback loops, the company will start to lose its ground gradually.

The best way to identify the feedback loops is by observing the system. You don’t have to work at an E&P company to actually observe the system on site. Over time, if you read enough and talk to enough people in the field, you will be able to identify the feedback loops. The hardest part is sensing when the dominating feedback loops change and a negative reinforcing feedback starts to develop. This is why there are value traps. Think about Blackberry, Nokia and Kodak. Now you understand why Buffett doesn’t invest in technology stocks.

I hope my article is simple enough to understand yet at the same time, spark some reflections. Any comments will be greatly appreciated.


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