“Systematic Noise” Barber, Odean & Zhu (2003)
The “noise” in the title of this paper refers to fluctuations in assets prices that are not based on information. It originates from a paper by Fischer Black, which states that a certain level of noise is unavoidable, as a level of uninformed investor activity is needed to provide markets with liquidity. This is unlike the famous “no-trade theorem”, where rational traders agree on asset prices without trading against each other. Of course we see a lot of trading in actual stock and currency markets, and it can be argued that this trading provides socially useful liquidity – allowing investors to buy or sell without unduly affecting prices.
Early views of finance assumed that noise would not lead to distortions. Either investor mistakes would be uncorrelated and hence cancel out in aggregate, would diminish over time as these investors lost capital, or rational traders would arbitrage any abnormal profit opportunities away. A paper by De Long and colleagues showed that this need not be the case: “noise” traders create their own risk which arbitrageurs on limited time horizons cannot eliminate. Noise traders might even make above-average returns in the long run due to their overconfidence! My own view is that noise hurts investor returns and negatively affects the economy through the bursting of asset price bubbles.
This paper uses two large datasets to make the following observations. There is a high correlation for individual investor purchases, more so than when it comes to sales. When it comes to stocks that have risen there are two countervailing biases. The disposition effect dominates at short lags (the last three months), where individual investors tend to sell stocks that have risen recently. At slightly longer lags (1year+) return chasing dominates, where individual investors buy stocks that have a more sustained recent history of price rises.
Efforts to moderate the systematic trading decisions of individual investors should therefore focus primarily on their buying decisions. The authors of the current study list two major causes: attention and the representativeness heuristic. Although this is probably the case historically, it’s my view that investors are merely grabbing on to these noisy heuristics because more fundamentally informative information is hard for them to process. Reducing the levels of noise in our markets would probably do a lot of good. First, professional investors cannot eliminate all pricing distortions on their own. And second, when they do reduce such effects it will always be through a zero-sum transfer away from individual investors. Reducing these mistakes in the first place would be a much more equitable solution.