IDEAS home Printed from https://ideas.repec.org/
MyIDEAS: Log in (now much improved!) to save this article

Is Noise Trading Cancelled Out by Aggregation?

  • Hongjun Yan

    ()

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

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.

If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.

File URL: http://dx.doi.org/10.1287/mnsc.1100.1167
Download Restriction: no

Article provided by INFORMS in its journal Management Science.

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

as
in new window

Handle: RePEc:inm:ormnsc:v:56:y:2010:i:7:p:1047-1059
Contact details of provider: Postal:
7240 Parkway Drive, Suite 300, Hanover, MD 21076 USA

Phone: +1-443-757-3500
Fax: 443-757-3515
Web page: http://www.informs.org/
Email:


More information through EDIRC

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:

as in new window
  1. Ernst Fehr & Jean-Robert Tyran, 2005. "Individual Irrationality and Aggregate Outcomes," Journal of Economic Perspectives, American Economic Association, vol. 19(4), pages 43-66, Fall.
  2. Hirshleifer, David, 2001. "Investor Psychology and Asset Pricing," MPRA Paper 5300, University Library of Munich, Germany.
  3. Suleyman Basak & Hongjun Yan, 2008. "Equilibrium Asset Prices and Investor Behavior in the Presence of Money Illusion," Yale School of Management Working Papers amz2402, Yale School of Management, revised 01 Aug 2009.
  4. Wei Xiong & Hongjun Yan, 2006. "Heterogeneous Expectations and Bond Markets," NBER Working Papers 12781, National Bureau of Economic Research, Inc.
  5. Jeanne, Olivier & Rose, Andrew K, 1999. "Noise Trading and Exchange Rate Regimes," CEPR Discussion Papers 2142, C.E.P.R. Discussion Papers.
  6. Bernard Dumas & Alexander Kurshev & Raman Uppal, 2009. "Equilibrium Portfolio Strategies in the Presence of Sentiment Risk and Excess Volatility," Journal of Finance, American Finance Association, vol. 64(2), pages 579-629, 04.
  7. Miller, Edward M, 1977. "Risk, Uncertainty, and Divergence of Opinion," Journal of Finance, American Finance Association, vol. 32(4), pages 1151-68, September.
  8. J. Michael Harrison & David M. Kreps, 1978. "Speculative Investor Behavior in a Stock Market with Heterogeneous Expectations," The Quarterly Journal of Economics, Oxford University Press, vol. 92(2), pages 323-336.
  9. Hongjun Yan, 2008. "Natural Selection in Financial Markets: Does it Work?," Yale School of Management Working Papers amz2648, Yale School of Management, revised 01 May 2008.
  10. Yeung Lewis Chan & Leonid Kogan, 2002. "Catching Up with the Joneses: Heterogeneous Preferences and the Dynamics of Asset Prices," Journal of Political Economy, University of Chicago Press, vol. 110(6), pages 1255-1285, December.
  11. Campbell, John & Viceira, Luis, 1999. "Consumption and Portfolio Decisions When Expected Returns are Time Varying," Scholarly Articles 3163266, Harvard University Department of Economics.
  12. Cox, John C. & Huang, Chi-fu, 1989. "Optimal consumption and portfolio policies when asset prices follow a diffusion process," Journal of Economic Theory, Elsevier, vol. 49(1), pages 33-83, October.
  13. John Y. Campbell, 2002. "Consumption-Based Asset Pricing," Harvard Institute of Economic Research Working Papers 1974, Harvard - Institute of Economic Research.
  14. Merton, Robert C., 1980. "On estimating the expected return on the market : An exploratory investigation," Journal of Financial Economics, Elsevier, vol. 8(4), pages 323-361, December.
  15. Elyès Jouini & Clotilde Napp, 2010. "Unbiased Disagreement in Financial Markets, Waves of Pessimism and the Risk-Return Trade-off," Review of Finance, European Finance Association, vol. 15(3), pages 575-601.
  16. G.M. Constantinides & M. Harris & R. M. Stulz (ed.), 2003. "Handbook of the Economics of Finance," Handbook of the Economics of Finance, Elsevier, edition 1, volume 1, number 2.
  17. Jose A. Scheinkman & Wei Xiong, 2003. "Overconfidence and Speculative Bubbles," Journal of Political Economy, University of Chicago Press, vol. 111(6), pages 1183-1219, December.
  18. Dumas, Bernard, 1989. "Two-Person Dynamic Equilibrium in the Capital Market," Review of Financial Studies, Society for Financial Studies, vol. 2(2), pages 157-88.
  19. Jiang, Wang, 1996. "The term structure of interest rates in a pure exchange economy with heterogeneous investors," Journal of Financial Economics, Elsevier, vol. 41(1), pages 75-110, May.
  20. Basak, Suleyman, 2000. "A model of dynamic equilibrium asset pricing with heterogeneous beliefs and extraneous risk," Journal of Economic Dynamics and Control, Elsevier, vol. 24(1), pages 63-95, January.
  21. Jegadeesh, Narasimhan & Titman, Sheridan, 1993. " Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency," Journal of Finance, American Finance Association, vol. 48(1), pages 65-91, March.
  22. Detemple Jerome & Murthy Shashidhar, 1994. "Intertemporal Asset Pricing with Heterogeneous Beliefs," Journal of Economic Theory, Elsevier, vol. 62(2), pages 294-320, April.
  23. De Bondt, Werner F M & Thaler, Richard, 1985. " Does the Stock Market Overreact?," Journal of Finance, American Finance Association, vol. 40(3), pages 793-805, July.
  24. Shleifer, Andrei, 2000. "Inefficient Markets: An Introduction to Behavioral Finance," OUP Catalogue, Oxford University Press, number 9780198292272, December.
  25. Brad M. Barber & Terrance Odean & Ning Zhu, 2009. "Do Retail Trades Move Markets?," Review of Financial Studies, Society for Financial Studies, vol. 22(1), pages 151-186, January.
  26. G.M. Constantinides & M. Harris & R. M. Stulz (ed.), 2003. "Handbook of the Economics of Finance," Handbook of the Economics of Finance, Elsevier, edition 1, volume 1, number 1.
  27. Ron Kaniel & Gideon Saar & Sheridan Titman, 2008. "Individual Investor Trading and Stock Returns," Journal of Finance, American Finance Association, vol. 63(1), pages 273-310, 02.
Full references (including those not matched with items on IDEAS)

This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

When requesting a correction, please mention this item's handle: RePEc:inm:ormnsc:v:56:y:2010:i:7:p:1047-1059. See general information about how to correct material in RePEc.

For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Mirko Janc)

If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

If references are entirely missing, you can add them using this form.

If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

Please note that corrections may take a couple of weeks to filter through the various RePEc services.

This information is provided to you by IDEAS at the Research Division of the Federal Reserve Bank of St. Louis using RePEc data.