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The Size and Incidence of the Losses from Noise Trading

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

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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File URL: http://www.nber.org/papers/w2875.pdf
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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
Date of revision:
Publication status: published as The Journal of Finance, Vol. XLIV, No. 3, pp. 681-696, (July 1989).
Handle: RePEc:nbr:nberwo:2875
Note: ME
Contact details of provider: Postal: National Bureau of Economic Research, 1050 Massachusetts Avenue Cambridge, MA 02138, U.S.A.
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  1. N. Gregory Mankiw & Jeffrey A. Miron & David N. Weil, 1987. "The Adjustment of Expectations to a Change in Regime: A Study of the Founding of the Federal Reserve," NBER Working Papers 2124, National Bureau of Economic Research, Inc.
  2. 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.
  3. 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.
  4. J. Bradford De Long & Andrei Shleifer & Lawrence H. Summers & Robert J. Waldmann, . "Noise Trader Risk in Financial Markets," J. Bradford De Long's Working Papers _124, University of California at Berkeley, Economics Department.
  5. Robert J. Barro, 1988. "Interest-Rate Smoothing," NBER Working Papers 2581, National Bureau of Economic Research, Inc.
  6. 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.
  7. Sanford J. Grossman & Merton H. Miller, 1988. "Liquidity and Market Structure," NBER Working Papers 2641, National Bureau of Economic Research, Inc.
  8. Roll, Richard, 1984. "Orange Juice and Weather," American Economic Review, American Economic Association, vol. 74(5), pages 861-80, December.
  9. Campbell, J.Y. & Kyle, A.S., 1988. "Smart Money, Noise Trading And Stock Price Behavior," Papers 95, Princeton, Department of Economics - Financial Research Center.
  10. 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.
  11. Kyle, Albert S, 1985. "Continuous Auctions and Insider Trading," Econometrica, Econometric Society, vol. 53(6), pages 1315-35, November.
  12. Stein, Jeremy C, 1987. "Informational Externalities and Welfare-Reducing Speculation," Journal of Political Economy, University of Chicago Press, vol. 95(6), pages 1123-45, December.
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