NOISE TRADERS, MARKET BUBBLES, AND
INFORMATION CASCADES
Brad De Long, an economist from U.C. Berkeley, has studied noise
traders extensively. He has found fascinating evidence suggesting that,
contrary to Friedman's hypothesis, noise traders can stick around for a
long time and exert considerable influence on stock prices, even when the

noise trader's market assumptions are incorrect. Ironically, the very fact of
noise trader irrationality keeps them in business. This counterintuitive
finding requires some explanation.
The argument made by Friedman and later Fama was that rational
traders—arbitrageurs—would take the other side of the noise trader
transactions. In so doing the arbitrageurs would make money while contributing
to market efficiency by pushing prices back in line. But a paper
written by De Long, Schleifer, Summers, and Waldmann explains why
arbitrageurs may fail to aggressively take advantage of noise traders'
market misperceptions.16
Unlike buy-and-hold investors, arbitrageurs have relatively short time
horizons. (Actually, so do lots of portfolio managers who are subject to quarterly
mark-to-market evaluations.) Moreover, being rational, they are riskaverse.
The arbitrageurs' short-term time horizon precludes them from taking
positions opposite noise traders if they fear that the noise traders will persist
in their irrational behavior for extended periods of time. Since noise trader
feedback loops tend to be self-reenforcing, it is entirely possible for stocks
(or, for that matter, bonds) to be priced away from their fundamental values
for considerable periods of time. Not only can securities be priced incorrectly
for extended periods of time, but the limited ability of arbitrageurs to take the
other side of noise trader transactions increases market volatility. Increased
market volatility implies that returns are higher than they would otherwise be
to compensate investors who rationally trade off risk and reward.
On the other hand, noise traders are not risk averters—they simply
go where the action is, or at least where they think it is. As a result some
noise traders earn superior returns because they hold assets that are riskier
than average. And they are riskier than average because of noise
trader–induced volatility. In effect, the noise traders have created their
own high-risk space in which some earn superior returns (and survive)
while the rest lose their shirts. But there is more to it than that: Noise
traders can be significant contributors to market bubbles. And electronic
trading can either reduce or increase the likelihood and severity of market
bubbles, depending on institutional arrangements.
The metaphor of a market bubble is a useful one, even granting that
market bubbles are (generally) recognized only after they have been punctured.
Consider what a market bubble really is (pricing far out of line with
fundamental values, generally with significant leverage) and how it forms
(by aggregating misinformation and pricing it as fact). The formation of
market bubbles is driven by a phenomenon known to economists as an information
cascade, in which the sequence of decision making determines (or at
least greatly influences) the outcome. What makes information cascades particularly
problematic is that they are self-reinforcing, the way crowd behavior
tends to be. As the German philosopher Francis Schiller once put it,
"Anyone taken as an individual is tolerably sensible and reasonable—as a
member of a crowd, he at once becomes a blockhead." On the other hand,
former Treasury Secretary Robert Rubin has pointed out that heading for the
exit when someone yells fire isn't necessarily irrational either.