What is a Noise Trader?
Let me explain what a noise trader is. In academic finance, especially when we're talking about the Efficient Markets Hypothesis (EMH), the term noise trader refers to investors who decide to buy or sell based on factors they think are useful, but these factors really don't give them any edge over just picking randomly.
Key Takeaways
You should know that noise traders act on signals they believe will beat random returns, but that belief isn't grounded in reality. The concept stems from the idea that market price movements include 'noise' unrelated to solid analysis of a security's value. This has led to the oversimplified view that fundamental analysis is the real signal while technical analysis is just noise. To really get this, you need to look at the noise trader agenda for a clearer picture.
Understanding a Noise Trader
Conventional thinking says noise traders drive high-volume trading days by making irrational, emotional decisions. But think about it—high-volume days are often led by institutional investors, who are supposed to be the most informed and researched. The stereotype lumps in novices and technical analysis followers as noise traders. Strictly speaking, anyone using systems that underperform the market averages fits here, no matter the method. That's why definitions in the literature are inconsistent; rational investing isn't standardized. Some experts claim noise traders pump up prices in bull markets and drag them down in bears, creating what mainstream investors call noise trader risk.
Technical Traders
Technical traders often get labeled as noise traders because their strategies ignore company fundamentals. But this assumes fundamental analysis always beats random or market returns, which isn't true for everyone. The semi-strong EMH questions both technical and fundamental indicators for predictable outperformance. Noise traders, following any unproven signals, make up a big chunk of daily trading volume. Active technical analysts and day traders base moves on price patterns from charts, and while most don't beat the market, a few do succeed beyond random. Even so, conventional views still call them noise traders, though that might not be fair if their signals work. Regardless, high trade volumes from them can swing stock prices up or down, adding noise to market pricing.
The Noise Trader Agenda
Edwin Burton and Sunit Shah introduced the noise trader agenda in their book 'Behavioral Finance' (Wiley, 2013), and it's referenced in the CMT Association's Level I Exam materials. This gives us a practical way to think about noise traders. They've noted that people buy and sell stocks for many silly reasons, and no one claims all traders are fully rational—observation proves otherwise. But just having noise traders doesn't debunk the EMH. To challenge it, two conditions must hold, which they call the noise trader agenda.
The Two Conditions of the Noise Trader Agenda
- Noise trader behavior must be systematic; they can't just cancel each other out—if some are overly optimistic and others pessimistic, their effects might neutralize, so there needs to be herd-like activity from a large group or a small one with big assets behaving similarly.
- Noise traders must survive economically over time; if they only lose money, their impact is minimal, so they need to make substantial, persistent profits in some conditions, or else they're just easy targets for smarter traders, as Friedman put it.
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