Discuss the implications of the paradox that although financial theory assumes that investors are rational in practive, few if any investors appear to approach investments decisions in a rational manner. Can Noise Traders Survive? 1. Introduction Noise Trader is a financial term introduced by Kyle (1985) and Black (1986). It refers to a stock trader who lacks access to inside information and makes irrational investment decisions (De Long et al. , 1990). Traditional financial theories are often based on the assumption that all the investors are rational.
The burgeoning behavioral finance departs from classical financial theory by dropping this basic assumption (Carty, 2005). In recent years, there has been a growing interest in studying the behaviour and effects of noise traders. Friedman (1953) and Fama (1965) argue that noise traders are irrelevant because they will be driven out of market by rational investors who trade against them. On the contrary, Black (1986) argues that noise traders can survive in the long run, and the entire financial market cannot function properly without noise traders.
This essay will attempt to demonstrate that noise traders can make profits and survive in the long run, they can maintain a price impact and provide liquidity to the market. In order to demonstrate this, first, this essay will be specifically focusing on efficient-market hypothesis (EMH), which is a representative traditional financial theory based on rational investors assumption. Both empirical and theoretical evidence will be given in order to demonstrate the discrepancy between the rational investors assumption and real financial markets.
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Second, this essay will further explain how noise traders can survive in the long run, even sometimes earn higher expected returns than rational investors. Finally, it should be noted that noise trading is essential to financial market as its impact on asset pricing and benefits for market liquidity. 2. Illogicality of efficient-market hypothesis Efficient-market hypothesis (EMH) assumes that financial markets are "informationally efficient" (Fama, 1965). All investors can make rational investment decisions based on full disclosure of information.
Their argument against the importance of noise traders points out that if the price of an asset diverges from its fundamental value, rational arbitrageurs will buy the undervalued shares on one exchange while sell the same amount of overvalued shares on another exchange (Shleifer, 2000). The actions of rational arbitrageurs will drive the price back to its fundamental value. In the long run, therefore, noise traders will consistently lose money to rational arbitrageurs, thus eventually disappear from the market (De Long et al. , 1990).
In order words, noise traders cannot survive in the financial market because their expected returns are negative. However, although efficient-market hypothesis is a cornerstone of modern financial theory, it is often disputed by investors and researchers both empirically and theoretically. The theoretical paradox of EMH and empirical evidence against EMH in real financial markets will be further explained by the following examples. The Grossman-Stiglitz paradox (Grossman and Stiglitz, 1980) testifies that financial market can not be "informationally efficient".
Grossman and Stiglitz argue that ”because information is costly, prices cannot perfectly reflect the information which is available, since if it did, those who spent resources to obtain it would receive no compensation” (Grossman and Stiglitz, 1980, p. 405 ). If a market is informationally efficient, it means that all relevant information is reflected in market prices. Therefore there is no incentive to collect the information. However, if no one will pay to collect the information, the information then can not reflect in the prices.
In summary, The Grossman-Stiglitz paradox contradicts efficient-market hypothesis, which might prove that efficient-market is not the real feature of financial market. There are also other paradoxes that are seemingly impossible to explain according to efficient-market hypothesis. From the perspective of rational arbitrageurs, if noise traders are all eventually driven out of markets, there will be no price discrepancies for arbitrage. Thus the rational arbitrageurs will also disappear from the markets. In that case, how can the markets maintain a non-arbitrage equilibrium?
From the perspective of noise traders, if noise traders are all driven out of markets, how do the markets generate the original noise traders? It seems clear that those two paradoxes serve as evidence of the existence of noise traders. Efficient-market hypothesis also states that it is impossible for investors to consistently out-perform the average market returns, or in other words, “beat the market”, because the market price is generally equal to or close to the fair value (Fama, 1965). It is impossible, therefore, for investors to earn higher returns through purchasing undervalued stocks.
Investors can only increase their profits by trading riskier stocks. However, empirically speaking, there is a large quantity of real financial examples to support that stocks are not always traded at their fair value. On Monday October 19, 1987, the financial markets around the world fell by over 20%, shedding a huge value in a single day (Ahsan, 2012). It serves as example that market price can diverge significantly from its fair value. In addition, Warren Buffett has consistently beaten the market over a long period of time, which also contradicts efficient-market hypothesis . Thus, the two empirical examples above show that there is a huge discrepancy between real financial markets and efficient-market hypothesis rational investors assumption. However, how do noise traders survive from rational investors and arbitrageurs? 3. Explanation of noise traders’ survival The DSSW model (De Long et. al. , 1990) further explains how noise traders can exist in the long run. The efficient-market hypothesis argues that if asset price diverges from its fair value by noise traders, rational arbitrageurs will trade against them hence push the price back to its fair value.
However, it is far from the truth in real financial market. If noise traders are too optimistic about stock and have raised up the price of the stock from its fundamental value, an arbitrageur will bear huge risk selling the stock because noise traders optimistic beliefs will not change for a long time, thus the price will not return, or be pushed up even further by noise traders (De Long et. al. , 1990). The risk rational arbitrageurs bears trying to change noise traders’ opinions is named “noise trader risk”. Since rational arbitrageurs are risk-averse, the noise trader risk will limit their willingness to trade against noise traders.
De Long et. al (1990) argue that “the arbitrage does not eliminate the effects of noise because noise itself creates risk. ” Therefore the noise traders can exist in the long run. De Long et. al (1990) also argue that noise traders may even earn higher expected returns than rational investors. If noise traders are over bullish about an asset and invest more, it means they bring additional noise trader risk into the asset, therefore rational arbitrageurs will find the asset less attractive because arbitrageurs are risk-averse investors.
Noise traders, especially those overconfident investors, invest more in the risky asset than rational investors. Overconfident traders take on more risk and hence earn higher profits than their rational counterparts. De Long et. al (1990) say that “noise traders can earn higher expected returns solely by bearing more of the risk that they themselves create”. It is reasonable to conclude that noise traders can survive in the long tun and may even make more profits than rational investors. This may lead us to ask is there any significance of noise traders existing in financial markets? . Significance of noise traders The significance of noise traders can be divided into two parts, namely the benefits for market liquidity and the impact on asset prices. First, noise trader is the indispensable component of financial market. Black (1986) argues that if all investors are rational, there will be very little trading in individual assets. It means there is no incentives for investors to trade in the shares of an individual firm against those who share the same information and same beliefs on the stock.
Traders will invest in mutual funds, or portfolios, or index futures instead of individual firms. However, individual shares are price foundations of mutual funds, portfolios and index futures (Black, 1986). Therefore, the entire financial market depends on liquidity in individual assets provided by noise traders. Second, noise traders can maintain a large price impact. According to an empirical research on on Dow Jones Industrial Average and S&P500 returns, the price impact of rational sentiments is greater than that of irrational sentiments (Verma et al, 2008).
Verma et al (2008) also argue that stock market returns have a immediate and positive response to noise trading. Therefore, it seems clear that noise trading is the essential ingredient in financial market since it is beneficial for market liquidity and it has huge price impact on stocks. Conclusion In conclusion, this essay has demonstrated that in spite of the basic model significance, traditional financial theory’s rational investors assumption is unrealistic. Noise traders can survive in the long run, and may even earn higher expected returns than rational investors.
Noise trading is indispensable component of financial market, and has significant effects on asset pricing and benefits for market liquidity. The financial market equilibrium is achieved by the coexist of noise traders and rational traders. However, the existing theories are not enough to fully explain every aspects of this extremely sophisticated financial system. There still remains a large number of puzzles and anomalies for us to further explore.
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