Behavioral finance FAQ / Glossary (Noise)

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Dates of related message(s) in the Behavioral-Finance group (*):

Year/month, d: developed / discussed, i: incidental

Noise trader / Noise trading

02/2i,4i,10i  - 03/1i - 04/1i - 07/7i + see boredom, overtrading,

trend following, hyperactivity, information, technical analysis,

cognitive, signal, cascade

Dear, I heard noise downstairs in the shop.

Is it the cat or do we take the gun?

Definition #1 (system noise)

Engine purr

Noise is a minor, slightly noticeable but common type of events,

due to the ordinary vibration of a system, which is poor in real information

The "Sound of silence" as the song says.

This makes it differ from a signal (see that word).

Not only a noise does not bring anything relevant, but it might drown

some crucial signals and make them inaudible!

Noise is like ants at the picnic!

Definition #1b (market noise)

Noisy markets?

Market noises often take the form of small price moves

without real changes in economic situations and prospects

Definition #2 (noise trading)

Following the decibels?

Noise trading is a compulsive / hyperactive buying and selling activity

(see overtrading) in financial markets,

which is performed in the absence of meaningful new information, except

erratic minor price moves, trifle or misunderstood news or unverifiable rumors.

Those frantic investor moves (see overtrading, boredom):

Not only are driven by market noises, as a flow of irrelevant information

that do not really change the asset's fundamentals.

But are also themselves a main source of market noise by

initiating more erratic price moves unrelated to those fundamentals.

Definition #2b (noise trader)

Any noise makes them jump.

A noise trader is somebody who practices noise trading, exclusively, continuously,

and indiscriminately.

A market insomniac?

Noise traders usually imitate other traders

and follow the trends.

When they see a price rise or fall, they ride that jumpy horse.

They might even give less importance to information that are more

fundamental but which potential effects take more time and efforts to analyze.

Definition #2c (noise trader risk)

Market disturbance by noisy players

Noise traders create market anomalies, and risks for investors who base

their valuations on fundamental analysis.

The risk is that, although market prices differ from their "fundamental" valuations,

the difference can get amplified instead of corrected.

The reason is that noise traders trust other traders' moves more than the fundamentals.

Therefore they mimic those other players even when they are erring

(see cascade, herding, mimicry....).

They put themselves also in a risky position, as those other traders, who are also

hyperactive, can change erratically their mood and behavior.

What are the types of market noises?

Noises from the street and noises from home

Nothing better to listen?

Those rather meaningless market information, but which market traders

are addictive to interpret as decisive, usually take the form of:

Some minor "exogenous" information ( anecdotic news,

wrongly considered as changing the economic fundamentals),

The "daily chatter" of financial medias, bloggers, tip givers / sellers,

(oops, let us call those people "financial experts": see "obedience to experts").

Those people met at the village pub can always explain what is going around

with a "good story" (see story).

They also spread gossips and rumors, like did Madame de Sévigné

commenting the little events of the French Royal court...

Or most often minor vibrations / zigzags

in market prices and volumes.

They are random blips due mostly to... noise traders who act erratically,

upon whims more than rationally or upon relevant information.

Noise traders interpret those noises, even if produced by other noise traders,

Sometimes as mispricing that offer arbitrage opportunities, in the hope

that the price will swing back (why not, although this is an hazardous bet)

More often as signals of either the birth of a short price trend or a

confirmation of a long price trend.

They see an opportunity to make money by following the scent.

Here comes the "representativeness heuristic" (see that phrase), when they

see technical analysis configurations everywhere, as signs in the sky.

Noise trading and trend following: how noise traders operate

Routine and speed.

First, let us say that noise traders can make some money in rather eventless periods

when a trend is rather settled.

Then noises are the only pieces of wild game on the plate and they become the main market pricing factor.

But it is a stressful activity for those jungle rovers.

* They need the speed of a tiger (or of a quantum computer) to prey on their protein sources.

* Also they can be easily wiped out of the financial ecosystem when the market climate changes.

Usually, noise traders base their decisions on:

Sometimes any blip in the "newsflow" (see "information") of "exogenous"

information (= those that alter economic fundamentals, not directly the financial sphere),

Certainly, some "spin doctors" know the importance of feeding the market with frequent

shots of information, one of the drugs it is addicted to.

But crucial information (those that really change the business prospects) are not that frequent.

No policy maker, company, business guru, rumor-monger, has the inventive capability

to release a breaking news, considered important, every 15 minutes like a cuckoo clock.

More often minor "endogenous" information

= those concerning the market itself, such as its day to day or intraday moves that reflect

what other traders do.

Among those sources, technical analysis is a purely endogenous market tool.

Why are market noises not "filtered"?

Why do some consider noises as information?

Noise traders by definition do not "filter" real information / signal from "noises".

Also their actions create their own "noises":

noise trading brings more noise trading, as seen in the "cascade" article.

Of course, we have to admit that noise filtering / screening is far from easy, as:

Some news that might look trite are in fact weak signals (see that phrase) showing that

major evolution are in the making and have to be taken into account.

What is at play also, is a cognitive overload (see that phrase) and the related human stress,

when facing a massive and increasing "newsflow", hard to follow and to sort.

All this makes it difficult for people to focus their attention on what is the most important,

or to use it rationally and efficiently.

Noise trading, overtrading and trend following: what effects?

What do noises bring to the market? Din or good music?

Those noise operators spend time doing intraday, or at least short term, buying and selling.

This "overtrading" (see that word) has several effects:

Its usefulness is to add liquidity to markets by boosting the transaction volume.

In practice, it creates a quasi continuous presence of counterparts for buy and sell orders,

It brings a non negligible source of fees for brokers,

On the other hand, it is also a far from negligible source ...of costs for traders.

This plays against the profitability of their trades and also, often, their survival as market players.

It tends to bring market excesses .

Stock markets, and other financial markets, mostly when they are "bubblish",

have numerous noise traders that take the trend itself as a signal.

Here noise trading and trend following go hand in hand.

Do we have here noise-driven CAPM instead of information-driven CAPM?

All that makes noise traders most of the time "trend followers" (see trend following).

We have here an anomaly compared to the efficient market hypothesis and its offspring, the CAPM

(see the related glossary articles).

Unless we accept, in the "weak form" of that famous hypothesis, that not only fundamental data and events,

but also endogenous market information (noise) and investor perceptions play a part in market pricing.

When reality strikes and replaces noise

Good bye, noise, hello thunder!

A change of sentiment by some of those traders, who realize suddenly

how market values went far from fundamental values, is sometimes the random "butterfly wing flip"

that shifts the entire market trend from bullish or bearish to the opposite direction.

This applies mostly to crashes that are looming in unbalanced situations

when they have all reasons to happen, but which often strike when no crucial

additional breaking news on fundamental issues occurs.

(*) To find those messages: reach that Behavioral-Finance group and, once you are there, 1) click "messages", 2) enter your query in "search archives".

Members of the Behavioral Finance Group, please vote on the glossary quality at Behavioral-Finance/polls

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