Discuss the implications of the paradox that although financial theory assumes that investors are rational in practive, few if any investors appear to approach investments decisions in a rational manner.
Can Noise Traders Survive?
Noise Trader is a financial term introduced by Kyle (1985) and Black (1986). It refers to a stock trader who lacks access to inside information and makes irrational investment decisions (De Long et al., 1990). Traditional financial theories are often based on the assumption that all the investors are rational. The burgeoning behavioral finance departs from classical financial theory by dropping this basic assumption (Carty, 2005). In recent years, there has been a growing interest in studying the behaviour and effects of noise traders. Friedman (1953) and Fama (1965) argue that noise traders are irrelevant because they will be driven out of market by rational investors who trade against them. On the contrary, Black (1986) argues that noise traders can survive in the long run, and the entire financial market cannot function properly without noise traders. This essay will attempt to demonstrate that noise traders can make profits and survive in the long run, they can maintain a price impact and provide liquidity to the market. In order to demonstrate this, first, this essay will be specifically focusing on efficient-market hypothesis (EMH), which is a representative traditional financial theory based on rational investors assumption. Both empirical and theoretical evidence will be given in order to demonstrate the discrepancy between the rational investors assumption and real financial markets. Second, this essay will further explain how noise traders can survive in the long run, even sometimes earn higher expected returns than rational investors. Finally, it should be noted that noise trading is essential to financial market as its impact on asset pricing and benefits for market liquidity.
2. Illogicality of efficient-market hypothesis
Efficient-market hypothesis (EMH) assumes that financial markets are "informationally efficient" (Fama, 1965). All investors can make rational investment decisions based on full disclosure of information. Their argument against the importance of noise traders points out that if the price of an asset diverges from its fundamental value, rational arbitrageurs will buy the undervalued shares on one exchange while sell the same amount of overvalued shares on another exchange (Shleifer, 2000). The actions of rational arbitrageurs will drive the price back to its fundamental value. In the long run, therefore, noise traders will consistently lose money to rational arbitrageurs, thus eventually disappear from the market (De Long et al., 1990). In order words, noise traders cannot survive in the financial market because their expected returns are negative. However, although efficient-market hypothesis is a cornerstone of modern financial theory, it is often disputed by investors and researchers both empirically and theoretically. The theoretical paradox of EMH and empirical evidence against EMH in real financial markets will be further explained by the following examples. The Grossman-Stiglitz paradox (Grossman and Stiglitz, 1980) testifies that financial market can not be "informationally efficient". Grossman and Stiglitz argue that ”because information is costly, prices cannot perfectly reflect the information which is available, since if it did, those who spent resources to obtain it would receive no compensation” (Grossman and Stiglitz, 1980, p.405 ). If a market is informationally efficient, it means that all relevant information is reflected in market prices. Therefore there is no incentive to collect the information. However, if no one will pay to collect the information, the information then can not reflect in the prices. In summary, The Grossman-Stiglitz paradox contradicts efficient-market hypothesis, which might prove...
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