Noise Trader Risk

Noise Trader Risk

The risk of a loss on an investment that comes from a noise trader. A noise trader is an investor who makes decisions based on feelings such as fear or greed, rather than fundamental or technical changes to a security. If enough noise traders panic, they can drive down the price of the security unnecessarily. Suppose an investor owns 1,000 shares of a stock and they are currently at $50 per share. If noise traders overreact to bad news, the price could drop to $40 per share without any fundamental justification. This costs the investor $10,000. The possibility that this could happen is noise trader risk. See also: Behavioral economics.
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We find ADR return affected by noise trader risk and increases (decreases) when investors are irrationally optimistic (pessimistic).
1990) develop a noise trader risk model which argues that when investment decisions are made based on market noise, the decisions are irrational and unpredictable because they are led by investor sentiment in general.
1990) develop a noise trader risk model in which irrational noise trader sentiment drives security prices from their fundamental values.
As a result, the noise trader risk caused by investor sentiment is unpredictable and renders rational arbitrages ineffective.
Both noise trader risk and investor sentiment refer to the irrational behavior of investors.
Our reason is that in a noisy market, noise trader risk is high because investor sentiment will change more abruptly in such an environment where there is an abundant supply of stimulus.
Table I shows that noise trader risk is important even in the presence of institutional investors.
Table I and II confirm that noise trader risk is present in the ADR market.
Noise trader risk similarly reduces arbitrage effectiveness because arbitrageurs bear the risk that noise traders will continue to be irrational, therefore maintaining, or even increasing, the mispricing.
Because the initial ex ante assessment of the portfolio investment is not observable to the fund investor, the investor then may use the investment's ex post outcome as a proxy of the arbitrageur's skill, with the effect of exposing the arbitrageur's human capital to both fundamental and noise trader risk because the fund investor may mistakenly treat a loss that really results from bad luck as evidence of bad judgment.
This interaction between noise trader risk and the agency costs of arbitrage can plausibly lead to bubble-like conditions.
Morck, Yeung, and Yu propose that weak private property rights impede informed trading and increase systematic noise trader risk.