What is a Noise Trader?
Noise trader is generally a term used in academic finance studies associated with the Efficient Markets Hypothesis (EMH). The definition is often vaguely stated throughout the literature though it is mainly intended to describe investors who make decisions to buy or sell based on factors they believe to be helpful but in reality will give them no better returns than random choices.
- Noise traders trade on signals they believe to generate better than random returns, however this belief is not well founded.
- The idea of a noise trader came from the notion that price action has "noise" which is unrelated to the signal of sound analysis about security value.
- Such notions have led to the contradictory and oversimplified view that fundamental analysis is true signal and technical analysis is mere noise.
- A better consideration for identifying noise trading is to understand the concept of the noise trader agenda.
Understanding a Noise Trader
Conventional wisdom posits that noise traders are considered to be substantial contributors to high-volume trading days because it is thought that these traders are making irrational decisions and responding emotionally. However high-volume trading days are inevitably driven by institutional investors who are among the most informed and should be making the most well-researched investing decisions.
The category of traders that are stereotyped as noise traders includes novices and those who trade primarily based on technical analysis. However, those who don't trade the market averages and instead follow trading systems that under perform the market, regardless of the factors involved, should, strictly speaking, be lumped into the same category. This is the reason that the definition is inconsistent and often unclear in the literature because the definition of what exactly constitutes rational investing is also not a standard definition.
Some professional analysts and academics like to say that noise traders overinflated the price of securities in bullish trading periods and depressed the price of securities in bearish trading. For mainstream investors, these affects can be known as noise trader risks.
Technical traders are often considered noise traders since their trading strategies are usually unrelated to company fundamentals. But this assumes a study of company fundamentals generates better returns than random choices or market averages--and this is certainly not the case for all traders and investors who follow company fundamentals. The semi-strong form of the EMH would categorize both technical and fundamental indicators as suspect in generating predictably better than random returns.
Noise traders, those who follow unproven signals of any kind, form a substantial portion of the market’s trading volume on any given day. Active technical analysts and full-time day traders make trades throughout the trading day based on price action indicators and patterns that are derived from daily price series charts. However a small portion of these are actually much more successful than random returns or the market averages. Conventional wisdom would still label these noise traders, but that designation is perhaps unwarranted since they clearly are following signals that matter at some level.
Regardless of the validity of their signal, those who contribute to an unusually high volume of daily trades can substantially affect a stock’s price either positively or negatively, and thus are considered to induce noise into market pricing.
The Noise Trader Agenda
Edwin Burton and Sunit Shah introduced the concept of the Noise Trader agenda to help better frame a discussion of noise traders. This concept was published in their text titled, "Behavioral Finance," (Wiley, 2013) and it is further quoted in the CMT Association's Level I Exam book. This concept explains a more useful and practical way of thinking about noise traders. They explain as follows:
"it has long been known that there are many, often silly, reasons that people buy and sell stocks. No one pretends that all traders and investors are completely rational; common observation suggests that is not the case. But the very existence of noise traders is not sufficient to invalidate the EMH. In order to show that the EMH is in trouble, at least two conditions must be met. We will call these two conditions the noise trader agenda:
Noise trader behavior must be systematic. Noise traders must be shown not to simply cancel one another out. If some are too optimistic and others are too pessimistic, then one group may simply cancel out the effect of the other. Instead, there must be something like herd activity, such that a large group of noise traders, or a small group with a large amount of assets, behave in a similar manner.
Noise traders need to survive economically for a significant period of time. If all noise traders do is lose money through their noise trading, then their impact will be limited. Noise traders need to make substantial and persistent profits under some conditions. Otherwise, noise traders are simply cannon fodder, as Friedman suggests, for the smart traders."