Mental Model:

Feedback Loops - When The Output Influences The Input

by Alex Mason | Nov 25, 2020 | Episodes, Mental Model | 0 comments

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Mental Details

Description

  • Cause and effect is a generally understood principle - one thing happens and that causes another thing to happen. But, what about when the effect comes back to influence the cause? This is known as a feedback loop.
  • In today's episode we explore the general concept of a feedback loop, and then apply it to how we look at markets as individual investors.

Transcript

  • Alex Mason: Hi, I'm Alex Mason, host of stock stories. This is the podcast where we decode investing principles by analyzing the business behind the stock, as well as learning about mental models in order to help you become a better investor. You ready? Let's go.
  • [00:00:43] All right. All right. Welcome. Welcome. Welcome to the stock stories podcast. My name is Alex Mason. I am your host and stock storyteller and yes, every week we go through. Mental models as well as case studies of individual companies, including, but not limited to the S&P 500 index, we're working our way through that entire index.
  • [00:01:13] Last week, we talked about advance auto parts. I hope you enjoyed that episode as we dove a little bit deeper into the specialty auto parts retailing business. Okay. And today we have a little bit of a different episode for you today. We're going into a mental model. This is usually the type of episode that I'd like to do about once a month or so.
  • [00:01:37] And it just kind of gives that balance, you know, between the practical side of investing, looking at the case, studies really digging into the companies with the more academic side, the more theoretical side, the more philosophical side. And that's what mental models are all about. If you're new to the show, a mental model is.
  • [00:01:57] Is basically a thought experiment or an idea that you can use to solve problems. And it's often applicable to many different areas of life, not just investing, although we certainly discuss the investing context here, but just applicable to life in general in life becomes a lot easier when you're able to piece together different situations or different.
  • [00:02:24] Ideas or paradigms together. And that's really the purpose of why I think mental models are so important, frankly. I wish that they were talked about more often in the investing space and also just in general and podcasts in general, I just haven't really seen or heard that much material related to mental models.
  • [00:02:45] So an episode like the one we're doing today is my contribution to that. So without further ado, let's go ahead and get into today's episode today. We're talking about feedback loops.
  • [00:03:12] All right. Talk about the mental model of feedback loops. So the way that this episode is structured is first we'll talk about just the basic definition of what that means. What is a feedback loop, then we'll go into an explanation of the concept and then we'll close out with a description of how we can apply this mental model to our investing practice.
  • [00:03:38] So first let's talk about the basic definition. What is a feedback loop? Well a feedback loop is a process in a system where the output of a system has some kind of an influence on the input of the system. So I'll repeat that feedback loops are processes in the system where the output of a system has an influence on the input of a system.
  • [00:04:03] So that is the basic definition of what a feedback loop is put in the simplest terms that I can. All right. Now let's talk about an explanation of what this concept actually means. So feedback loops, they're basically what caused systems to make changes based on what is happening, not just based on the initial input.
  • [00:04:27] So there are different kinds of systems there's closed systems and open systems is one way to think about it. If you think of an example, Of kind of a, a system that doesn't have a feedback loop. Maybe that'll that'll help with the contrast here. If I was to take an Apple in my hand and then drop it, gravity would force the Apple to fall on the ground.
  • [00:04:55] Boom. Done. So you have cause and effect it's a one-way street. There's nothing that the ground is going to do that has some kind of impact upon my hand. Gravity doesn't impact anything other than the Apple that's acting on it. And that's pretty much it in this very simple system you have. Step one, I release the Apple from my hand.
  • [00:05:19] Step two gravity takes over. It makes it fall to the floor. That's it? Nothing about the Apple hitting the floor, changes how I release the Apple. So that's kind of an example of, I guess, the anti feedback loop or rather the existence of a system that doesn't have a feedback loop in it. Now let's look at an example, a simple one of where a feedback loop actually takes place.
  • [00:05:44] So the next time that you're home and say, you walk by your bathroom, look at the sink in the bathroom. Now likely there is a small hole somewhere inside the ceramic bowl of your bathroom sink. This hole is called an overflow drain. Now imagine that you turn the faucet on in your sink and you fill up the bowl with water.
  • [00:06:09] Now, an input to the system is the water level of the sink that gradually rises. Now, let's assume for this example that the stopper is closed. So water actually builds up gradually in the bowl. So you turn on the faucet, water fills the bowl, and then it's gradually rising. Now the output of the system is.
  • [00:06:29] The water level eventually reaches that little small overflow drain hole in the bowl. So you have input and you have output, but what happens now at this point, water flows into that little hole and then, and reduces the overall water level because the water has somewhere to escape, right? So that is the output influences the input now, not completely, but to a certain degree.
  • [00:06:58] So notice how in this scenario, the water level, it won't actually go all the way down. It's just going to go down just enough to keep the sink from overflowing the water. Level's not going to go all the way down to being completely empty because you have the stopper there, right? The stopper there is keeping water from escaping out of the bottom of the sink, but you also have this little hole at the top.
  • [00:07:21] That's preventing the water level from completely overflowing. So that's an example of. A simple feedback loop in a mechanical fluid type of example. So an effect has an impact on the initial cause not just the other way around, and this can make understanding systems kind of a complex task, because if we look at things too simply, it seems that the cause and effect loop, it makes for a circular argument, which would defy logic.
  • [00:07:53] Now in the case of the sink, the drain provides feedback, but only enough to prevent the overflow. It doesn't completely change the input of the water level, such that it drains out of the sink completely. So that's an example of an optimization of the mechanical fluid system toward this end result of you having kind of this constant high level of water.
  • [00:08:19] In the sink and it's not too high, it's not too low, but you kind of put a check on the system that influences the input. Well, where does all of this come from? So that's just an example of a mechanical system that you could probably find and test right now in your own home. But this is actually a specific discipline, this specific field, and it comes from the field of engineering.
  • [00:08:46] And it's called control theory. And now if you never heard of control theory before, it's kind of the basis for lot electrical engineering and some parts of mechanical engineering too. So there's this whole theory behind what feedback loops actually are. And of course, a lot of math involved to back it up.
  • [00:09:07] So the idea has roots in mechanical engineering with a man named John Maxwell. So Maxwell, he was a Scottish physicist way back in the 18 hundreds. And he did a lot of groundbreaking research, mostly around magnetism and electricity. But what we're concerned with today is his work that involved the beginnings of modern control theory.
  • [00:09:31] He's often credited with kind of articulating that theory and being one of the first to do it. So he wrote about this mechanical device called a governor. Now, this was a little confusing for me to like, learn about what a governor is, because it's not like an everyday object you would see in the modern world, but it was used a lot for things like steam engines back in the day.
  • [00:09:57] And basically what it is is it's got these two metal balls that are connected to a piston by some rods and as the piston spins fast. And faster and faster, the balls move further and further away from the piston shafts. And that creates what's called a centrifugal force that regulates the speed for the piston itself.
  • [00:10:22] It's a little bit hard to have this idea come across, purely with audio, but if you were to go to YouTube and just type in a governor's centrifugal force or something like that, you would see an example of what I mean, but this was the kind of device used in steam engines and things like that back in the day.
  • [00:10:41] But basically the principle of how this works is as you spin something around, it moves further and further away from you. Maybe a simpler example of actually that I just thought of is this. If you were to take ball and tie it to a string, and then you have one end of the string in your hand, and you're just swinging the ball around and around.
  • [00:11:05] Well, That string is going to rise higher and higher, the faster that you spin it because of that centrifugal force. And so that output is. Potentially going to have an input on how quickly you have to keep up with the rate at which you're spinning the ball in order to have it be at that high level. So I don't know maybe that was more complex.
  • [00:11:32] I'm not sure, but I tried to put it in another context to paint the picture for you, but sorry, if that was too much physics, let's look at a different example that does not involve math or science. To kind of bring the point home. So picture a classroom filled with children. Now, if a teacher asks a question and then let's say everyone in the class is super enthusiastic and they just all raise their hand up to answer the question.
  • [00:12:00] Now, imagine the teacher chooses the student. That's sitting in the front of the class to answer the question. Okay. Now, imagine the scenario repeated over and over. So the same children raise their hands, but then the same child who's sitting up at front is picked to speak over and over again. Now, what do you think would happen in this case?
  • [00:12:20] I mean, if I were you or that were me, eventually I, as a child would receive social feedback that, Hey, I'm not going to get called on. So why bother raising my hand? And so if this were to play out in real life, eventually a lower and lower percentage of the kids will end up raising their hands as the teacher asks more questions.
  • [00:12:44] So the teacher seeing the lack of enthusiasm of the other kids may subconsciously pick that same kid more and more because of what they're observing. So this is an example of a social feedback loop. Do you see what I'm saying? Because if the kids are not raising their hands. The teacher thinks, Oh, well they're not raising their hands anyway.
  • [00:13:07] So I'll just keep on picking on this one student. So it's influencing that system of selection in a social setting. So you can apply this to social settings, to mechanical devices, electrical devices, all sorts of things. And feedback loops like many mental models. They're universal. They're all around us.
  • [00:13:28] So you have social situations, mechanical and electrical systems, and it's also present in biology. Feedback loops exist in so many different types of systems. So I hope you're getting the idea there. Now let's talk about the mental model in the context of investing. Let's talk about investing. How does this play out in the economy or in the markets?
  • [00:13:54] Well, One thing that I think about is speculation. So speculation in high-risk fast growing glamour stocks, when a stock's price rises, people see this and they get excited. They want a piece of the action. And so they invest their money. When enough people do this, the price of the stock must rise higher because collectively the demand for it.
  • [00:14:22] Far outweighs the supply of the shares. So if you can imagine a company, I'll just say Coca-Cola and let's just pretend Coca-Cola has a million shares outstanding, and everyone is clamoring for one of those shares. Well, since there's a fixed number of shares available, there has to be a Some kind of demand for each of those shares and that's expressed in terms of money in terms of the price per share.
  • [00:14:49] So right now I think Coke is trading at around 50 ish dollars per share somewhere around there. So if people, all of a sudden got excited about Coca-Cola because it discovered how to infuse cannabis in Coca-Cola or something like something like that, then maybe the, the share price would shoot up. And in doing so that would be a signal to investors who maybe couldn't care less about Coca-Cola during normal circumstances, but guess what?
  • [00:15:19] They just saw the price double or triple or quadruple. So then they think, Oh, I got to get in on this action. I have to get in on these Coke shares. Well, the number of Coke shares that exist is still fixed. So the demand is rising. The supply is the same and therefore the price of the stock goes higher. Okay. So you get the idea.
  • [00:15:38] Now here's what happens. Here's where the feedback loop comes in. When people buy the shares and the price goes up, another investor is going to see that price rise and say, Oh, I really need to get in on this action. Coke just invented cannabis, infused Coca-Cola or whatever it is. And then they go crazy and they buy more shares.
  • [00:15:59] And then the price keeps going up and up and up and up and up. So the process keeps repeating and repeating, and this is what's called speculative buying. So all of this happens until one day investors start to consider. Other factors more than just the hype. Maybe they begin to think somewhat rationally.
  • [00:16:21] Maybe they start thinking about how this product is going to get to market. What are the competitors? What are the risks has this product line even made any money yet? What what's going on here? And then someone decides, okay, this is too much, I'm going to cash out. And then they dump the stock, the price drops at this point.
  • [00:16:41] And usually when this happens, it happens very fast. This is kind of what happens in bear markets or corrections. So this is actually what happened back in, I think it was Holland that had the tulip bubble many centuries ago. There was a time in Holland where tulips and I'm talking about the flower tulips, they were extremely popular.
  • [00:17:10] They became this, this like fashion item, this symbol of status and tulip bulbs. We're in really high demand. For some reason, people just started wanting them. And because there was a fixed number of tulips available, they started trading for higher and higher prices, just like a share of stock can trade for higher and higher prices.
  • [00:17:35] Well, this kept going on and on. And the speculative tulip bubble. Grew to ridiculous proportions and then eventually it burst and then the price collapsed. And we've seen this again and again, throughout history, not just with stocks or with Tulip bulb flowers, but with other asset classes as well. Another that comes to mind is actually pineapples.
  • [00:18:00] Pineapples were actually really popular in Europe, a couple centuries ago, they were a symbol of wealth and status and prestige. And you know, today we think of pineapples is just, you know, it's just a fruit, you get at the grocery store, but pineapples had this high status attached to it, but fundamentally pineapples, they haven't changed.
  • [00:18:22] So what did change, what changed is our perception about how we view things and when we get caught up. In a feedback loop of feeding frenzy of speculation, it can lead to really poor buying decisions. You probably noticed by now, if you've listened to many of the other mental model episodes for the show that there's so many mental models that come into play with speculative buying or speculative purchasing of stocks, it's just, it's crazy.
  • [00:18:54] There's so many mental models at play and feedback loops. Definitely is incorporated within that. So we talked about what happens when a stock will rise as a result of a feedback loop. But the opposite is also true. When stocks are falling, people are so afraid that a stock will fall further, that they continue to sell it.
  • [00:19:16] Even if it's priced well below its intrinsic value. Now other investors they'll see that resulting price decline, they get that feedback and then they continue to sell their shares. So this selling frenzy is what allows actually value investors like you and I to swoop in buy those shares of our choice at a discount at great prices.
  • [00:19:38] And that's, that's really what value investing is buying below intrinsic value. So we can use this to our advantage when prices fall, even if it's very temporary, sometimes it only happens in a matter of minutes or a matter of days, but. If we're patient with our capital and we know what companies we want to buy, and we know the prices that we want to acquire them at when stocks trade, trade below those prices, we can be confident that we're getting good value.
  • [00:20:09] And so we can use that mental model of that feedback loop to our advantage. Not all investors are rational. In fact, as human beings, we're all irrational in many ways, and just by injecting a little bit of rationality into this decision-making process, we can really improve our results and improve our lives.
  • [00:20:28] So things are always as simple as far as what I'm talking about here with the stock market, with prices going up and down, and that being as a result of some kind of a feedback loop, that's just one example. And I'm simplifying certainly a little bit here, but the principle generally is true prices in a way, are a form of feedback from the market.
  • [00:20:51] People then make decisions based on those prices and that. Again, influences future prices. So that's just an example there of. Of the principal at work. And so that is the mental model of feedback loops. You have an input, you have an output and then the output has some kind of bearing on the input. It might not be direct.
  • [00:21:17] It might not be obvious, but maybe the second and third order effects of a decision end up coming back around and influencing the process yet again. And that's exactly, frankly, what happens with compounding too think about compound interest and the compounding of returns and not just the stock market, but.
  • [00:21:39] Universally really, as a principle when you have something feeding on itself and building and building, you get this nonlinear process as a result of this feedback of additional capital of additional resources of additional time, whatever the case may be. So mental models, I think that's another thing that's cool about them is they don't just exist really in isolation.
  • [00:22:00] They connect with each other depending on the situation and the context. So you can apply. This feedback loop, plus the compounding mental model in your portfolio to make better decisions, knowing that you're getting high nonlinear returns over time. If you continue to invest in good stocks and good opportunities.
  • [00:22:21] So that is the principle of feedback loops. And that's going to wrap up the episode today. So I hope you enjoyed this episode. I hope you enjoyed learning about this mental model and we're going to go through as many mental models as I can find as many useful ideas that I can share with you. I'm committed to doing that, not just to, to learn and solidify the ideas myself, but to help you get better along with me as we go through this journey together as investors now, next week, we'll be.
  • [00:22:53] Going right back into the company episodes, as we're tackling our goal of going through every single company in the S&P 500 and some more companies as well. So I hope you join us for that next week. And I appreciate you listening. If there's. Any way that you can help me with the show, it would be such a help.
  • [00:23:14] If you were to share this show with a friend, share the show with someone who you think would benefit from these stories. And I really appreciate that. Thank you so much in advance. All right. Well, that's it for today's episode and we'll see you next week here on stock stories.
  • [00:23:56] The information presented on stock stories is for informational educational and entertainment purposes only you and you alone are responsible for your investment and financial decisions. Please consult an appropriate tax legal or financial advisor that analyze your specific situation in the context of your goals and circumstances.

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