DEFINITION of Noise Trader Risk
Noise Trader Risk is a form of market risk associated with the investment decisions made by so-called noise traders. The higher the volatility in market price for a particular security, the greater the associated noise trader risk - that is, the risk associated with largely uninformed traders who trade on the "noise" in the market instead of the "signal". These traders are largely trend following, emotional, and undisciplined.
Behavioral finance researchers have attempted to isolate this risk in order to explain and capitalize upon the sentiment of the majority of investors. Noise trader risk is assumed to be more readily found in small-cap stocks, but has also been identified mid- and large-caps.
BREAKING DOWN Noise Trader Risk
A noise trader is a general term used to describe traders or investors who make decisions regarding buy and sell trades in securities markets without the support of professional advice or advanced fundamental or technical analysis. Trading by noise traders tends to be impulsive and based on irrational exuberance, or emotions such as fear or greed. These investors typically follow trends, exhibited herding behavior, and overreact to both good and bad news.
Noise trader risk describes the negative effect of such irrational or uninformed trading on otherwise sound investment analysis in a security. So, an informed trader may have a model that suggests the value of XYZ shares is $10, but due to a piece of bad news in the media, the stock is oversold by noise traders down to $8. The smart analyst believes that the negative news story should only move the expected value down to $9.90, but despite this the noise traders dominate the market activity, at least in the short run. This risk implies that even well-informed or rational traders can be undermined by the irrationality of the crowd. At the same time, if a patient "smart" money investor is able to understand the noise trading risk, he or she can buy the stock when it is at $8 with confidence that it should soon rise.
If the noise trader risk for a particular stock is high, an issuance of good news related to a particular company may influence more noise traders to buy the stock, artificially inflating its market value.