Noise Trader Risk in Financial Markets

TLDR

The study introduces an overlapping‑generations asset‑market model in which irrational noise traders with erroneous stochastic beliefs influence prices and earn higher expected returns. In the model, the unpredictable beliefs of noise traders generate price risk that discourages rational arbitrageurs from aggressively betting against them. The model shows that price deviations from fundamentals can arise without fundamental risk, and that noise traders, by bearing the risk they create, earn higher expected returns, thereby explaining anomalies such as excess volatility, mean reversion, closed‑end fund underpricing, and the Mehra‑Prescott equity‑premium puzzle.

Abstract

We present a simple overlapping generations model of an asset market in which irrational noise traders with erroneous stochastic beliefs both affect prices and earn higher expected returns. The unpredictability of noise traders' beliefs creates a risk in the price of the asset that deters rational arbitrageurs from aggressively betting against them. As a result, prices can diverge significantly from fundamental values even in the absence of fundamental risk. Moreover, bearing a disproportionate amount of risk that they themselves create enables noise traders to earn a higher expected return than rational investors do. The model sheds light on a number of financial anomalies, including the excess volatility of asset prices, the mean reversion of stock returns, the underpricing of closed-end mutual funds, and the Mehra-Prescott equity premium puzzle.