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The Size and Incidence of the Losses from Noise Trading

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

Abstract

Recent empirical research has identified a significant amount of volatility in stock prices that cannot be easily explained by changes in fundamentals; one interpretation is that asset prices respond not only to news but also to irrational "noise trading." We assess the welfare effects and incidence of such noise trading using an overlapping-generations model that gives investors short horizons. We find that the additional risk generated by noise trading can reduce the capital stock and consumption of the economy, and we show that part of that cost may be borne by rational investors. We conclude that the welfare costs of noise trading may be large if the magnitude of noise in aggregate stock prices is as large as suggested by some of the recent empirical literature on the excess volatility of the market.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 2875.

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Date of creation: Dec 1989
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Handle: RePEc:nbr:nberwo:2875

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  1. Grossman, S.J. & Miller, M.H., 1988. "Liquidity And Market Structure," Papers 88, Princeton, Department of Economics - Financial Research Center.
  2. Mankiw, N Gregory & Miron, Jeffrey A & Weil, David N, 1987. "The Adjustment of Expectations to a Change in Regime: A Study of the Founding of the Federal Reserve," American Economic Review, American Economic Association, vol. 77(3), pages 358-74, June.
  3. John Y. Campbell & Albert S. Kyle, 1988. "Smart Money, Noise Trading and Stock Price Behavior," NBER Technical Working Papers 0071, National Bureau of Economic Research, Inc.
  4. Robert J. Barro, 1989. "Interest-Rate Smoothing," NBER Working Papers 2581, National Bureau of Economic Research, Inc.
  5. Stein, Jeremy C., 1987. "Informational Externalities and Welfare-Reducing Speculation," Scholarly Articles 3660740, Harvard University Department of Economics.
  6. De Long, J Bradford & Andrei Shleifer & Lawrence H. Summers & Robert J. Waldmann, 1990. "Noise Trader Risk in Financial Markets," Journal of Political Economy, University of Chicago Press, vol. 98(4), pages 703-38, August.
  7. Albert M. Wojnilower, 1980. "The Central Role of Credit Crunches in Recent Financial History," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 11(2), pages 277-340.
  8. Glosten, Lawrence R. & Milgrom, Paul R., 1985. "Bid, ask and transaction prices in a specialist market with heterogeneously informed traders," Journal of Financial Economics, Elsevier, vol. 14(1), pages 71-100, March.
  9. Kyle, Albert S, 1985. "Continuous Auctions and Insider Trading," Econometrica, Econometric Society, vol. 53(6), pages 1315-35, November.
  10. Roll, Richard, 1984. "Orange Juice and Weather," American Economic Review, American Economic Association, vol. 74(5), pages 861-80, December.
  11. Shiller, Robert J, 1981. "Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?," American Economic Review, American Economic Association, vol. 71(3), pages 421-36, June.
  12. LeRoy, Stephen F & Porter, Richard D, 1981. "The Present-Value Relation: Tests Based on Implied Variance Bounds," Econometrica, Econometric Society, vol. 49(3), pages 555-74, May.
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  1. The Ambiguity of Stock Value
    by Guest Author in the big picture on 2010-12-28 14:30:00
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