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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.

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File URL: http://dx.doi.org/10.1287/mnsc.1100.1167
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Article provided by INFORMS in its journal Management Science.

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

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Handle: RePEc:inm:ormnsc:v:56:y:2010:i:7:p:1047-1059
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