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.
References in periodicals archive ?
A greater proportion of unsophisticated retail traders in lottery stocks means greater noise trader risk and thus higher arbitrage risk.
This persistence is likely due to lottery stocks' noise trader risk. A larger retail trading proportion in lottery stocks increases the probability that irrational noise traders will contribute to a stock's deviation from fundamental value, which represents an arbitrage risk.
Waldmann, 1990, "Noise Trader Risk in Financial Markets," Journal of Political Economy, 98, 703-738.
Waldmann, "Noise Trader Risk in Financial Markets" Journal of Political Economy 98, pp.
We find ADR return affected by noise trader risk and increases (decreases) when investors are irrationally optimistic (pessimistic).
First, market noise leads to the existence of noise trader risk. De Long et al.
Bradford De Long et al., Noise Trader Risk in Financial Markets, 98 J.
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.
For example, he explains how the mispricing of closed-end funds is the logical consequence of arbitrage limited by noise trader risk. Unless the arbitrager has an infinite horizon and is never forced to liquidate, an arbitrager who buys a closed-end fund at a discount to net asset value while selling short its underlying portfolio (even if feasible and costless) will likely not have an effective arbitrage opportunity.
'Noise Trader Risk in Financial Markets', Journal of Political Economy, 98, 703-38.
The above setting also holds when the individual smart trader is risk-averse and there exists uncertainty with regard to the firm value (fundamental risk) and noise process (noise trader risk).
Morck, Yeung, and Yu propose that weak private property rights impede informed trading and increase systematic noise trader risk. They also conjecture that, in countries that protect public investors poorly from corporate insiders, intercorporate income shifting may make firm-specific information less useful to risk arbitrageurs and therefore impede its capitalization into stock prices.