Noise (market Sentiment) Flashcards
Shleifer and Summers – The noise trader approach in finance
Prices can be drifted away from the fundamental values, and not be corrected by arbitrage, because arbitrage has its own limitations, ie it is not possible to find perfect substitute assets, or there is no guarantee that mispricing will be corrected. Ex: in 80s 90s most Japanese stocks were probably overvalued as PE ratio was huge, then investors started to short sell expecting it to fall, but what happened was that they got even higher price, however subsequently crashed but it is an evidence that stocks can drift away further before correction.
What could drive the security prices away from their fundamental values? It is explained by the cause from Noise traders. Investors who trade on information, not necessarily related to fundamentals, ie information about sentiment signals.
Example of noise
1. Guru’s advises
2. Trading trend
3. Overreaction
4. Attaching too much emphasis on recent data
These are consistent with cognitive psychology of investor’s behaviour. Noise traders will not cancel out each other because they make similar mistakes ie correlated, thus reflect price. And they will not disappear, because sentiment will drive them.
Academics believe success depends on predicting fundamentals, but professionals consider additionally other investors attitude including noise traders. Therefore professional would buy even if stock were overpriced as long as sentiment is higher (noise traders are willing to pay even higher).
What it means is that Return of stock not only depend on β on a theoretical basis but also depend on variable sentiment.
R= rf + β (Rm – rf) + S this might explain equity premium puzzle as well.
Noise traders are problem
1. they add volatility =>
2. makes market more risky =>
3. increases cost of capital =>
4. increase cost of capital => less projects are undertaken => less economic activity=>less wealth created
Arguments in favour of noise traders
1. It is tractable and incorporates the EMH in extreme cases
2. Accurate description of financial market and doesn’t just explain anomalies
3. Provides new testable hypothesis
Closed end fund puzzle – fund shares sold at discount relative to price. The risks include risks of underlying shares and discount rate being widened. The second risk might remove sentiment as discount return widens.
