The Basics

Noise Trading

One of the more interesting topics I’ve come across in my delving into research in the area of Behavioral Finance is the term “noise trader”. I’ve been reading a paper on the subject which has former Treasury Secretary Larry Summers as one of the co-authors. To put it simply, noise traders are those who do not operate on a strictly rationale valuation basis when making buy/sell decisions in the market. In other words, if you’re reading this blog post you are almost certainly a noise trader in the way academia defines the term.

One of the things I find interesting is how Summer & Co. refer to the non-noise set of market participants as “sophisticated investors”. The implication is that these folks can build a proper valuation model with the correct inputs that correctly account for risk. The implication is that noise traders can’t correctly estimate future risk (among other things), while the so-called sophisticated investors never makes any errors in estimating all the contributing factors which go into a valuation calcuation. Not very realistic in a world of failable human actors, in the latter case, or in terms of valuing the abilities of some very smart researchers on the other.

What’s kind of funny is the expressed observation of the paper that noise traders make value investing a sub-optimal course. One the one side, noise traders are said to increase volatility, and thus risk, reducing asset prices (stocks, really) in terms of their attractiveness to the non-noise set. On the other side, the added volatility actually increases the returns accruing to a noise trading approach. I think a lot of traders will feel vindicated in this. 🙂

I haven’t gotten all the way through the paper, and there’s a lot of very academic stuff, so it’s not the easiest read in the world. For those with an inclination, though, it’s an interesting bit of intellectual discourse.