Noise Trading & Market Inefficiency
What is Noise Trading?
Noise Traders: Investors trading on "noise" (rumors, emotions, tips) rather than fundamental information.
Contrast:
- Information traders: Trade on fundamental analysis
- Noise traders: Trade on irrelevant factors
Sources of Noise
Rumors: "I heard this stock will be acquired"
Tips: Friend/broker recommendations without analysis
Technical Patterns: Chart shapes predicting future (no fundamental basis)
Emotions: Fear, greed, FOMO driving trades
Social Media: Reddit, Twitter hype
Why Noise Trading Matters
Creates Volatility: Noise trades push prices away from fundamental value
Generates Volume: Most daily trading is noise, not information
Limits Arbitrage: Noise trader risk—can push prices further wrong before correction
Profit Opportunity: Patient value investors profit when noise creates mispricings
Noise Trader Risk
Definition: Risk that noise traders push prices further from fundamentals, forcing rational arbitrageurs out before correction.
Example: During 1990s dotcom bubble, rational investors shorting overvalued tech stocks lost money for years as noise traders pushed prices higher. Many were forced to cover shorts before eventual crash.
Implication: "Markets can stay irrational longer than you can stay solvent" (Keynes)
Market Impact
Short-term: Noise dominates—high volatility, random price movements
Long-term: Fundamentals dominate—prices converge to intrinsic value
Trading Strategy: Value investors exploit noise by being patient (3-5 year horizons)
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