A:

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.

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