There are two theories that are used to describe how securities are priced in the stock market: the efficient market hypothesis (EMH) and the inefficient market hypothesis. The EMH states that all stocks are accurately priced according to their underlying value and, therefore, there are no opportunities for investors to "beat the market" because all relevant information about a stock is already reflected in its price. On the other hand, the inefficient market theory states that certain market forces work to create inequalities in a stock's price when compared to the true discounted value of its future cash flows. (For further reading, see What Is Market Efficiency and Working Through The Efficient Market Hypothesis.)

The concept of noise trading is one of those market forces that causes equity prices to deviate from their true values. The term noise describes the constant changes in market prices and volumes that cause investors to get confused about the market's direction. Noise trading has become a major aspect of behavioral finance, which examines the psychology behind an investor's trading decisions.

Most noise traders believe they are making sound investment decisions when they follow market noise. However, the trades they make are often not based on any fundamental data. Noise traders usually try to jump on the bandwagon and react quickly when they think noise is taking the market in a particular direction. Subsequently, they may make poor decisions by overreacting to good and bad news. Since the noise traders are always watching the price movements of equities and listening to other aspects of noise in the market, their trades can often have a short-term effect on the market. This is because the constant buying and selling done by these investors causes an increase in price volatility. As the time horizon of an investment increases, however, the effect of noise trading becomes less and less noticeable.

Noise trading can have long term effects in some very specific cases. For example, if enough noise traders jump on the same bandwagon regarding noise in the market, this can lead to the creation and escalation of a bubble like the one that formed during the dotcom craze in the late 1990s. When a bubble like this bursts, the market can be led into a longer term downturn.

To learn more, see Trading Without Noise, The Essentials Of Cash Flow and Introduction To Technical Analysis.

  1. How do mutual funds split?

    Mutual funds split in the same way that individual stocks split, but less often. Like a stock split, mutual fund splits do ... Read Full Answer >>
  2. Are mutual funds better than single stocks?

    Mutual funds offer advantages over individual stocks, including diversification and convenience. Investing in only a handful ... Read Full Answer >>
  3. What are some of the most common technical indicators that back up Doji patterns?

    The doji candlestick is important enough that Steve Nison devotes an entire chapter to it in his definitive work on candlestick ... Read Full Answer >>
  4. Tame Panic Selling with the Exhausted Selling Model

    The exhausted selling model is a pricing strategy used to identify and trade based off of the price floor of a security. ... Read Full Answer >>
  5. Point and Figure Charting Using Count Analysis

    Count analysis is a means of interpreting point and figure charts to measure vertical price movements. Technical analysts ... Read Full Answer >>
  6. What assumptions are made when conducting a t-test?

    The common assumptions made when doing a t-test include those regarding the scale of measurement, random sampling, normality ... Read Full Answer >>
Related Articles
  1. Investing Basics

    What Does In Specie Mean?

    In specie describes the distribution of an asset in its physical form instead of cash.
  2. Economics

    Calculating Cross Elasticity of Demand

    Cross elasticity of demand measures the quantity demanded of one good in response to a change in price of another.
  3. Investing Basics

    3 Key Signs Of A Market Top

    When stocks rise or fall, the financial fate of investors change, as well. There are certain signs that can reveal a stock’s course, and investors don’t need to be experts to spot them.
  4. Chart Advisor

    ChartAdvisor for October 2 2015

    Weekly technical summary of the major U.S. indexes.
  5. Investing Basics

    Tops Tips for Trading ETFs

    A look at two different trading strategies for ETFs - one for investors and the other for active traders.
  6. Investing

    How Diversifying Can Help You Manage Market Mayhem

    The recent market volatility, while not unexpected, has certainly been hard for any investor to digest.
  7. Fundamental Analysis

    Emerging Markets: Analyzing Colombia's GDP

    With a backdrop of armed rebels and drug cartels, the journey for the Colombian economy has been anything but easy.
  8. Technical Indicators

    Why MACD Divergence Is an Unreliable Signal

    MACD divergence is a popular method for predicting reversals, but unfortunately it isn't very accurate. Learn the weaknesses of indicator divergence.
  9. Investing

    Asset Manager Ethics: Rules Governing Capital Markets

    The integrity of the capital markets needs to be kept at utmost importance for all investors. This article shows how to maintain the integrity while investing.
  10. Investing News

    6 Signs You Are Addicted To Investing

    An addiction to trading can ruin your life and relationships. Not to mention the monetary costs. There are telltale signs that you've gone too far.
  1. Put-Call Parity

    A principle that defines the relationship between the price of ...
  2. Alpha

    Alpha is used in finance to represent two things: 1. a measure ...
  3. Capitalization Rate

    The rate of return on a real estate investment property based ...
  4. Capital Markets

    Capital markets are markets for buying and selling equity and ...
  5. Linear Relationship

    A statistical term used to describe the directly proportional ...
  6. Equity Market

    The market in which shares are issued and traded, either through ...

You May Also Like

Hot Definitions
  1. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
  2. Revenue

    The amount of money that a company actually receives during a specific period, including discounts and deductions for returned ...
  3. Normal Profit

    An economic condition occurring when the difference between a firm’s total revenue and total cost is equal to zero.
  4. Operating Cost

    Expenses associated with the maintenance and administration of a business on a day-to-day basis.
  5. Cost Of Funds

    The interest rate paid by financial institutions for the funds that they deploy in their business. The cost of funds is one ...
  6. Cost Accounting

    A type of accounting process that aims to capture a company's costs of production by assessing the input costs of each step ...
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!