The Snowball Effect as a Positive Feedback Loop

Subject: RE: The Snowball Effect

From: sbakshi@mdi.ac.in

Date: Fri, September 12, 2008 6:17 am

To:     "Ajay Singh Bhati"

Dear Ajay,

In my view, its not correct to always view positive feedback loops in business as destructive, though they well might be. For example a run on a bank can bring it down on its knees in a very short time period and it can spread (systemic risk) to other banks. Similarly stock market bubbles can be thought of positive feedback loops - high prices feed optimism which feeds high prices - it does not last for ever, but it can last for a long long time.

I think you're on the right track when you visualize a positive feedback loop as a mechanism which is nested inside a negative feedback loop. To illustrate, why do bear markets follow bull markets? Because over the long run, markets operate inside a negative feedback loop with built-in corrective mechanisms. When prices run too far away from underlying values, there are forces that pull them back. For example, when stocks become too cheap in relation to the replacement cost of the underlying assets, there is no incentive to create new capacity and industry consolidation is likely to take place wherein the strong players in an industry, instead of creating new capacity, buy out competitors.

Conversely, when stock prices rise so high that they become much more than the replacement cost of the underlying assets, strong incentives are created by those high prices, to create fresh capacity. So shortages follow gluts follow shortages.... - hence a negative feedback loop.

But what caused the speculative bubble in the first place? Why do people suddenly become euphoric about an industry or a sector and invest in it in unison? That part of the answer is better explained by positive feedback loops.

Its also important to view positive feedback loops as means of explaining some of the extreme business successes. I gave two examples in class of the dominant newspaper, and Wal-Mart. But one can think of others. For example, in some industries, the first mover has a big advantage. He goes and captures a very large part of the market and obtains scale economics. And once he's done that, it becomes very difficult to dislodge him. Airtel is one example which comes to mind. There are, I am sure, several other examples...

Rgds

||

==SB

Sir,

Can it assumed that snowball effects (positive feedback) constitute a small alternate parts of negative feedback loop? (Since in a negative feedback loop, balancing acts take place after increase in one of the aspects -- may be a result of snowball effect -- of the process. Also snowball effect generally ends with destruction resulting in the onset of the reverse process.)

Regards,

Ajay Singh Bhati

 -----Original Message-----

From: sbakshi@mdi.ac.in [mailto:sbakshi@mdi.ac.in]

Sent: Wednesday, September 10, 2008 7:34 AM

To: bfbv@mdi.ac.in

Subject: The Snowball Effect

Shareholder: You've acknowledged that it's a more difficult investment and business environment today than it was when you first started out. If you were starting out again today in your early thirties, what would you do differently or the same in today's environment to replicate your success? In short, how can I make $30 billion?

Buffett: Start young. As Charlie's always said, the big thing about it is we started building this little snowball on top of a very long hill. We started at a very early age in rolling the snowball down. And of course, the nature of compound interest is that it behaves like a snowball in sticky snow. The trick is to have a very long hill - which means either starting very young or living to be very old.

If I were doing it in the investment world, I would do it exactly the same way. If I were getting out of school today and I had $10,000 to invest, I'd start with the A's.. (The companies whose names begin with the letter "A") And I probably would focus on smaller companies - because I'd be working with smaller sums and there would be a greater chance that something would be overlooked in that arena.

Buffett: As Charlie said earlier it won't be like doing that in 1951 when you could leaf through and find all kinds of things that just leapt off the page at you. But that's the only way to do it. You have to buy businesses - or little pieces of businesses called stocks. You have to buy 'em at attractive prices. And you have to buy into good businesses. That advice will be the same 100 years from now. That's what investing is all about.

And you can't expect anybody else to do it for you. People will not tell you about wonderful, little investments. It's not the way the investment business is set up.

Buffett: When I first visited GEICO back in January of 1951, I went back to Columbia the rest of that year; but I subsequently went down to Blythe & Company, and actually to one other firm . that was a leading analyst of insurance. I thought I'd discovered this wonderful thing - so I'd see what these great investment houses that specialized in insurance stocks said. And they said I didn't know what I was talking about. It wasn't of any interest to them.

You've got to follow your own ideas - with the caveat that you've got to learn what you know and what you don't know. And within the arena of what you know, you have to pursue it very vigorously and act on it when you find it. You can't look around for people to agree with you. You can't look around for people to even know what you're talking about. You have to think for yourself. If you do, you'll find things. Charlie?

Munger: The hard part of the process for most people is the first $100,000. If you have a standing start at zero. Getting together $100,000 is a long struggle for most people. I'd argue that the people who get there relatively quickly are helped if they're passionate about being rational, very eager and opportunistic, and steadily under spend their income grossly. I think those three factors are very helpful.