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Noise Trading, Delegated Portfolio Management, and Economic Welfare

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  • James Dow
  • Gary Gorton

Abstract

We consider a model of the stock market with delegated portfolio management. All agents are rational: some trade for hedging reasons, some investors optimally contract with portfolio managers who may have stock-picking abilities, and portfolio managers trade optimally given the incentives provided by this contract. Managers try, but sometimes fail, to discover profitable trading opportunities. Although it is best not to trade in this case, their clients cannot distinguish 'actively doing nothing,' in this sense, from 'simply doing nothing.' Because of this problem: (i) some portfolio managers trade even though they have no reason to prefer one asset to another (noise trade). We also show that, (ii), the amount of such noise trade can be large compared to the amount of hedging volume. Perhaps surprisingly, (iii), noise trade may be Pareto-improving. Noise trade may be viewed as a public good. Results (i) and (ii) are compatible with observed high levels of turnover in securities markets. Result (iii) illustrates some of the possible subtleties of the welfare economics of financial markets.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 4858.

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Date of creation: Sep 1994
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Publication status: published as Journal of Political Economy, Vol. 105, no. 5 (October 1997): 1024-1050.
Handle: RePEc:nbr:nberwo:4858

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  1. James Dow & Gary Gorton, 1993. "Arbitrage Chains," NBER Working Papers 4314, National Bureau of Economic Research, Inc.
  2. Dow James & Gorton Gary, 1995. "Profitable Informed Trading in a Simple General Equilibrium Model of Asset Pricing," Journal of Economic Theory, Elsevier, vol. 67(2), pages 327-369, December.
  3. Grossman, Sanford J & Stiglitz, Joseph E, 1980. "On the Impossibility of Informationally Efficient Markets," American Economic Review, American Economic Association, vol. 70(3), pages 393-408, June.
  4. De Long, J. Bradford & Shleifer, Andrei & Summers, Lawrence H. & Waldmann, Robert J., 1990. "Noise Trader Risk in Financial Markets," Scholarly Articles 3725552, Harvard University Department of Economics.
  5. Grossman, Sanford J & Stiglitz, Joseph E, 1976. "Information and Competitive Price Systems," American Economic Review, American Economic Association, vol. 66(2), pages 246-53, May.
  6. Pagano, Marco, 1989. "Endogenous Market Thinness and Stock Price Volatility," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 56(2), pages 269-87, April.
  7. Ausubel, Lawrence M., 1990. "Partially-revealing rational expectations equilibrium in a competitive economy," Journal of Economic Theory, Elsevier, vol. 50(1), pages 93-126, February.
  8. Bhattacharya, Sudipto & Pfleiderer, Paul, 1985. "Delegated portfolio management," Journal of Economic Theory, Elsevier, vol. 36(1), pages 1-25, June.
  9. Allen, Franklin, 1990. "The market for information and the origin of financial intermediation," Journal of Financial Intermediation, Elsevier, vol. 1(1), pages 3-30, March.
  10. Ausubel, Lawrence M, 1990. "Insider Trading in a Rational Expectations Economy," American Economic Review, American Economic Association, vol. 80(5), pages 1022-41, December.
  11. J. Harold, 1990. "Regulation, Trading Volume and Stock Market Volatility," Revue économique, Presses de Sciences-Po, vol. 0(5), pages 923-938.
  12. Kyle, Albert S, 1985. "Continuous Auctions and Insider Trading," Econometrica, Econometric Society, Econometric Society, vol. 53(6), pages 1315-35, November.
  13. J. Harold Mulherin, 1990. "Regulation, Trading Volume and Stock Market Volatility," Revue Économique, Programme National Persée, vol. 41(5), pages 923-938.
  14. James Tobin, 1978. "A Proposal for International Monetary Reform," Eastern Economic Journal, Eastern Economic Association, vol. 4(3-4), pages 153-159, Jul/Oct.
  15. Trueman, Brett, 1988. " A Theory of Noise Trading in Securities Markets," Journal of Finance, American Finance Association, vol. 43(1), pages 83-95, March.
  16. Diamond, Douglas W. & Verrecchia, Robert E., 1981. "Information aggregation in a noisy rational expectations economy," Journal of Financial Economics, Elsevier, vol. 9(3), pages 221-235, September.
  17. Allen, Franklin & Gorton, Gary, 1993. "Churning Bubbles," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 60(4), pages 813-36, October.
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