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I plan to write a series of blog entries addressing Market Efficiency, Technical Analysis and Noise Traders. I felt inspired to write this series of entries upon re-reading “ A Non Random Walk Down Wall Street” by Andrew W. Lo and Craig MacKinlay.
Here are a few quotes that I would like you to consider as I work on my next entry:
“Perfectly information ally efficient markets are an impossibility, for if markets are perfectly efficient, the return to gathering information is nil, in which case there would be little reason to trade and markets would eventually collapse. Alternatively, the degree of market inefficiency determines the effort investors are willing to gather and trade on information; hence non-degenerate market equilibrium will arise only when there are sufficient profit opportunities, i.e., inefficiencies, to compensate investors for the cost of trading and information gathering. The profits earned by these industrious investors may be viewed as economic rents that accrue to those willing to engage in such activities.” This quote is attributable to Grossman,S., and J. Stiglitz, 1980, “On the impossibility of Informationally Efficient Markets,” American Economic Review, 70, 393-408.
Who are the providers of these rents?
Black (1986) gives us a provocative answer: noise traders, individuals who trade on what they think is information but is in fact merely noise. More generally, at any time there are always investors who trade for reasons other than informational for example, those with unexpected liquidity needs – and these investors are willing to pay up for the privilege of executing their trades immediately.”
Wikipedia has the following definition for Noise Traders:
A noise trader also known informally as an idiot trader, is described in the literature of financial research as a stock trader whose decisions to buy, sell, or hold are irrational and erratic. The presence of noise traders in financial markets can then cause prices and risk levels to diverge from expected levels even if all other traders are rational.
In finance, noise obtained a formal definition in a 1986 paper by Fischer Black: “Noise in the sense of a large number of small events is often a cause factor much more powerful than a small number of large events can be.”
A more academic definition of a noise trader goes as follows:
Irrational noise traders with erroneous stochastic beliefs both affect prices and earn higher expected returns. The unpredictability of noise traders’ beliefs creates a risk in the price of the asset that deters rational arbitrageurs from aggressively betting against them. As a result, prices can diverge significantly from fundamental values even in the absence of fundamental risk. Moreover, bearing a disproportionate amount of risk that they themselves create enables noise traders to earn a higher expected return than do rational investors.
I will close with a quote from an intellectual giant:
“If the reader interjects that there must surely be large profits to be gained… in the long run by a skilled individual who… purchase[s] investments on the best genuine long-term expectation he can frame, he must be answered… that there are such serious-minded individuals and that it makes a vast difference to an investment market whether or not they predominate… But we must also add that there are several factors which jeopardize the predominance of such individuals in modern investment markets. Investment based on genuine long-term expectation is so difficult… as to be scarcely practicable. He who attempts it must surely… run greater risks than he who tries to guess better than the crowd how the crowd will behave.”
John Maynard Keynes (1936), p. 157