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Is Noise Trading Cancelled Out by Aggregation?

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  • Hongjun Yan

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 a¿ect 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 due to 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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Bibliographic Info

Paper provided by Yale School of Management in its series Yale School of Management Working Papers with number amz2604.

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Date of creation: 01 Mar 2008
Date of revision: 01 Jan 2009
Handle: RePEc:ysm:somwrk:amz2604

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

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Citations

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

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