Is Noise Trading Cancelled Out by Aggregation?

38 Pages Posted: 25 Mar 2008 Last revised: 8 Feb 2010

Date Written: February 7, 2010

Abstract

Conventional wisdom suggests that investors' independent biases should cancel each other out and have little impact on equilibrium at the aggregate level. In contrast to this intuition, this paper analyzes models with biased investors and finds that biases often have a significant impact on the equilibrium even if they are independent across investors. First, independent biases affect the equilibrium asset price if investor demand for the asset is a nonlinear function of the bias. Second, even if the demand function is linear in the bias, it may still have a significant impact on the equilibrium due to the fluctuation of the wealth distribution. An initial run-up of the stock price makes optimistic investors richer, which then further pushes the stock price up and leads to lower future returns. This effect can lead to price overshooting, i.e., a negative expected future return. Similarly, an initial drop of the stock price leads to higher future returns. Simple calibrations show that a modest amount of biases can have a large impact on the equilibrium.

Keywords: Aggregation, bias, noise trading, behavioral finance

JEL Classification: B40, D90, G12

Suggested Citation

Yan, Hongjun, Is Noise Trading Cancelled Out by Aggregation? (February 7, 2010). Yale ICF Working Paper No. 08-10; AFA 2009 San Francisco Meetings Paper. Available at SSRN: https://ssrn.com/abstract=890899

Hongjun Yan (Contact Author)

DePaul University ( email )

1 East Jackson Blvd.
Chicago, IL 60604
United States

HOME PAGE: http://sites.google.com/view/hongjunyan

Register to save articles to
your library

Register

Paper statistics

Downloads
662
rank
37,788
Abstract Views
2,955
PlumX Metrics
!

Under construction: SSRN citations will be offline until July when we will launch a brand new and improved citations service, check here for more details.

For more information