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The Economic Consequences of Noise Traders

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  • J. Bradford De Long
  • Andrei Shleifer
  • Lawrence H. Summers
  • Robert J. Waldmann

Abstract

The claim that financial markets are efficient is backed by an implicit argument that misinformed "noise traders" can have little influence on asset prices in equilibrium. If noise traders' beliefs are sufficiently different from those of rational agents to significantly affect prices, then noise traders will buy high and sell low. They will then lose money relative to rational investors and eventually be eliminated from the market. We present a simple overlapping-generations model of the stock market in which noise traders with erroneous and stochastic beliefs (a) significantly affect prices and (b) earn higher returns than do rational investors. Noise traders earn high returns because they bear a large amount of the market risk which the presence of noise traders creates in the assets that they hold: their presence raises expected returns because sophisticated investors dislike bearing the risk that noise traders may be irrationally pessimistic and push asset prices down in the future. The model we present has many properties that correspond to the "Keynesian" view of financial markets. (i) Stock prices are more volatile than can be justified on the basis of news about underlying fundamentals. (ii) A rational investor concerned about the short run may be better off guessing the guesses of others than choosing an appropriate P portfolio. (iii) Asset prices diverge frequently but not permanently from average values, giving rise to patterns of mean reversion in stock and bond prices similar to those found directly by Fama and French (1987) for the stock market and to the failures of the expectations hypothesis of the term structure. (iv) Since investors in assets bear not only fundamental but also noise trader risk, the average prices of assets will be below fundamental values; one striking example of substantial divergence between market and fundamental values is the persistent discount on closed-end mutual funds, and a second example is Mehra and Prescott's (1986) finding that American equities sell for much less than the consumption capital asset pricing model would predict. (v) The more the market is dominated by short-term traders as opposed to long-term investors, the poorer is its performance as a social capital allocation mechanism. (vi) Dividend policy and capital structure can matter for the value of the firm even abstracting from tax considerations. And (vii) making assets illiquid and thus no longer subject to the whims of the market -- as is done when a firm goes private -- may enhance their value.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 2395.

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Date of creation: Oct 1987
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Publication status: published as "Noise Trader Risk in Financial Markets," Journal of Political Economy, Vol .98, No.4, (August 1990), pp.703-738.
Handle: RePEc:nbr:nberwo:2395

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References

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  1. Kyle, Albert S, 1985. "Continuous Auctions and Insider Trading," Econometrica, Econometric Society, vol. 53(6), pages 1315-35, November.
  2. French, Kenneth R. & Roll, Richard, 1986. "Stock return variances : The arrival of information and the reaction of traders," Journal of Financial Economics, Elsevier, vol. 17(1), pages 5-26, September.
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Citations

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Cited by:
  1. Takatoshi Ito & V. Vance Roley, 1988. "Intraday yen/dollar exchange rate movements: news or noise?," Research Working Paper 88-07, Federal Reserve Bank of Kansas City.
  2. Jeffrey Frankel and Kenneth Froot., 1991. "Exchange Rate Forecasting Techniques, Survey Data, and Implications for the Foreign Exchange Market," Economics Working Papers 91-158, University of California at Berkeley.
  3. Jeffrey M. Lacker & John A. Weinberg, 1990. "Takeovers and stock price volatility," Economic Review, Federal Reserve Bank of Richmond, issue Mar, pages 29-44.
  4. Patricia Fraser & Martin Hoesli & Lynn McAlevey, 2008. "House Prices and Bubbles in New Zealand," The Journal of Real Estate Finance and Economics, Springer, vol. 37(1), pages 71-91, July.
  5. David Peel & Alan Speight, 1994. "Testing for non-linear dependence in inter-war exchange rates," Review of World Economics (Weltwirtschaftliches Archiv), Springer, vol. 130(2), pages 391-417, June.
  6. Froot, Kenneth A. & Ito, Takatoshi, 1989. "On the consistency of short-run and long-run exchange rate expectations," Journal of International Money and Finance, Elsevier, vol. 8(4), pages 487-510, December.
  7. Lui, Yu-Hon & Mole, David, 1998. "The use of fundamental and technical analyses by foreign exchange dealers: Hong Kong evidence," Journal of International Money and Finance, Elsevier, vol. 17(3), pages 535-545, June.
  8. Shawn Fremstad, 2008. "Measuring Poverty and Economic Inclusion: The Current Poverty Measure, the NAS Alternative, and the Case for a Truly New Approach," CEPR Reports and Issue Briefs 2008-36, Center for Economic and Policy Research (CEPR).
  9. Froot, Kenneth A & Scharftstein, David S & Stein, Jeremy C, 1992. " Herd on the Street: Informational Inefficiencies in a Market with Short-Term Speculation," Journal of Finance, American Finance Association, vol. 47(4), pages 1461-84, September.
  10. Cripps, M., 1989. "Dealer behaviour and price volatility in asset markets," Discussion Paper 1989-50, Tilburg University, Center for Economic Research.
  11. Roland Gillet & Ariane Szafarz, 2004. "Marchés financiers et anticipations rationnelles," ULB Institutional Repository 2013/142648, ULB -- Universite Libre de Bruxelles.
  12. Naik, Narayan Y., 1997. "On aggregation of information in competitive markets: The dynamic case," Journal of Economic Dynamics and Control, Elsevier, vol. 21(7), pages 1199-1227, June.
  13. Fischer Black, 1988. "An Equilibrium Model of the Crash," NBER Chapters, in: NBER Macroeconomics Annual 1988, Volume 3, pages 269-276 National Bureau of Economic Research, Inc.
  14. Kenneth A. Froot & Maurice Obstfeld, 1989. "Intrinsic Bubbles: The Case of Stock Prices," NBER Working Papers 3091, National Bureau of Economic Research, Inc.
  15. Mervyn A. King & Jonathan I. Leape, 1987. "Asset Accumulation, Information, and the Life Cycle," NBER Working Papers 2392, National Bureau of Economic Research, Inc.
  16. Guy V. G. Stevens, 1989. "Developments and Prospects in Macroeconometric Modeling: A Comment," Eastern Economic Journal, Eastern Economic Association, vol. 15(4), pages 305-308, Oct-Dec.
  17. Pacces, Alessio M., 2000. "Financial intermediation in the securities markets law and economics of conduct of business regulation," International Review of Law and Economics, Elsevier, vol. 20(4), pages 479-510, December.

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