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Is Noise Trading Cancelled Out by Aggregation?

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Author Info

  • Hongjun Yan

    ()
    (Yale School of Management, Yale University, New Haven, Connecticut 06520)

Abstract

Conventional wisdom suggests that investors' independent biases should cancel each other out and have little impact on equilibrium at the aggregate level. In contrast to this intuition, this paper analyzes models with biased investors and finds that biases often have a significant impact on the equilibrium even if they are independent across investors. First, independent biases affect the equilibrium asset price if investor demand for the asset is a nonlinear function of the bias. Second, even if the demand function is linear in the bias, it may still have a significant impact on the equilibrium because of the fluctuation of the wealth distribution. An initial run-up of the stock price makes optimistic investors richer, which then further pushes the stock price up and leads to lower future returns. This effect can lead to price overshooting, i.e., a negative expected future return. Similarly, an initial drop of the stock price leads to higher future returns. Simple calibrations show that a modest amount of biases can have a large impact on the equilibrium.

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File URL: http://dx.doi.org/10.1287/mnsc.1100.1167
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Bibliographic Info

Article provided by INFORMS in its journal Management Science.

Volume (Year): 56 (2010)
Issue (Month): 7 (July)
Pages: 1047-1059

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Handle: RePEc:inm:ormnsc:v:56:y:2010:i:7:p:1047-1059

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Related research

Keywords: aggregation; bias; noise trading; behavioral finance;

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References

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  3. Wei Xiong & Hongjun Yan & Review Financial, 2007. "Heterogeneous Expectations and Bond Markets," Yale School of Management Working Papers amz2614, Yale School of Management, revised 01 Jun 2009.
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Citations

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Cited by:
  1. Roman Muraviev, 2013. "Market selection with learning and catching up with the Joneses," Finance and Stochastics, Springer, vol. 17(2), pages 273-304, April.
  2. Wei Xiong & Hongjun Yan, 2010. "Heterogeneous Expectations and Bond Markets," Review of Financial Studies, Society for Financial Studies, vol. 23(4), pages 1433-1466, April.
  3. Yang, Chunpeng & Li, Jinfang, 2014. "Two-period trading sentiment asset pricing model with information," Economic Modelling, Elsevier, vol. 36(C), pages 1-7.
  4. Cvitanic, Jaksa & Malamud, Semyon, 2011. "Price impact and portfolio impact," Journal of Financial Economics, Elsevier, vol. 100(1), pages 201-225, April.
  5. Yang, Chunpeng & Zhang, Rengui, 2013. "Dynamic asset pricing model with heterogeneous sentiments," Economic Modelling, Elsevier, vol. 33(C), pages 248-253.
  6. Yang, Chunpeng & Zhang, Rengui, 2014. "Dynamic sentiment asset pricing model," Economic Modelling, Elsevier, vol. 37(C), pages 362-367.
  7. Yu, Jianfeng & Yuan, Yu, 2011. "Investor sentiment and the mean-variance relation," Journal of Financial Economics, Elsevier, vol. 100(2), pages 367-381, May.
  8. He, Xue-Zhong & Shi, Lei, 2012. "Disagreement, correlation and asset prices," Economics Letters, Elsevier, vol. 116(3), pages 512-515.
  9. Yang, Chunpeng & Li, Jinfang, 2013. "Investor sentiment, information and asset pricing model," Economic Modelling, Elsevier, vol. 35(C), pages 436-442.

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