Noise Trader Risk in Financial Markets

J. Bradford De Long, Andrei Shleifer, Lawrence Summers and Robert Waldmann ()

Scholarly Articles from Harvard University Department of Economics

Abstract: We present a simple overlapping generations model of an asset market in which irrational noise traders with erroneous stochastic beliefs both affect prices and earn higher expected returns. The unpredictability of noise traders' beliefs creates a risk in the price of the asset that deters rational arbitrageurs from aggressively betting against them. As a result, prices can diverge significantly from fundamental values even in the absence of fundamental risk. Moreover, bearing a disproportionate amount of risk that they themselves create enables noise traders to earn a higher expected return than rational investors do. The model sheds light on a number of financial anomalies, including the excess volatility of asset prices, the mean reversion of stock returns, the underpricing of closed-end mutual funds, and the Mehra-Prescott equity premium puzzle.

Date: 1990
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Published in Journal of Political Economy -Chicago-

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Journal Article: Noise Trader Risk in Financial Markets (1990)
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