The Noise Trader Approach to Finance

TLDR

The approach assumes that some investors act on unsubstantiated sentiment and that arbitrage by rational traders is limited, creating persistent market inefficiencies. The paper reviews an alternative to the efficient markets approach that the authors and others have recently pursued. The model shows that sentiment‑driven demand, unchecked by limited arbitrage, influences security returns. The authors argue that this noise trader approach is superior to the efficient markets paradigm in many respects.

Abstract

This paper reviews an alternative to the efficient markets approach that we and others have recently pursued. Our approach rests on two assumptions. First, some investors are not fully rational and their demand for risky assets is affected by their beliefs or sentiments that are not fully justified by fundamental news. Second, arbitrage—defined as trading by fully rational investors not subject to such sentiment—is risky and therefore limited. The two assumptions together imply that changes in investor sentiment are not fully countered by arbitrageurs and so affect security returns. We argue that this approach to financial markets is in many ways superior to the efficient markets paradigm.