Noise Trader Risk

What Is Noise Trader Risk?

Noise trader risk is a form of investment risk associated with the decisions made by so-called noise traders — unskilled, uninformed, and/or novice retail traders that participate in the market and are largely trend following, emotional, and undisciplined. These traders can create price volatility and make apparently irrational decisions or mistakes that can affect prices to the detriment of professional or well-informed traders.

The higher the volatility in the market price for a particular security, the greater the associated noise there tends to be as these can attract the most novice traders.

Understanding Noise Trader Risk

A noise trader is a general term used to describe traders or investors who make decisions regarding buy and sell trades in securities markets without the support of professional advice or advanced fundamental or technical analysis. Trading by noise traders tends to be impulsive and based on irrational exuberance, or emotions such as fear or greed. These investors typically follow trends, exhibit herding behavior, and overreact to both good and bad news.

Noise trader risk describes the negative effect of such irrational or uninformed trading on otherwise sound investment analysis in a security. Just as a novice poker player can make objectively irrational or unusual moves that can confound a professional player's success, so too can a preponderance of noise traders interfere with professional traders in the market.

Behavioral finance researchers have attempted to isolate this risk in order to explain and capitalize upon the sentiment of the majority of investors. Noise trader risk is assumed to be more readily found in small-cap stocks but has also been identified in mid- and large-caps.

Also, as the media pumps out more and more content, there tends to be more headline risks for stocks and markets. The noise can sometimes move stocks and markets in the near term. However, it is important to understand that some noise is designed to stir emotions. Emotions are typically not a good indicator for investors.

The category of traders that are usually stereotyped as noise traders includes novices, trend chasers, and those who trade primarily based on technical analysis.

Example of Noise Trader Risk

As an example, an informed trader may have a model that suggests the value of XYZ shares is $10, but due to a piece of bad news in the media, the stock is now oversold by noise traders, with shares trading down to $8. The smart analyst believes that the negative news story should only move the expected value down to $9.90, but despite this, the noise traders dominate the market activity, at least in the short run. This risk implies that even well-informed or rational traders can be undermined by the irrationality of the crowd.

At the same time, if a patient smart money investor is able to understand the noise trading risk, they can buy the stock when it is at $8 with confidence that it should soon rise.

If the noise trader risk for a particular stock is high, an issuance of good news related to a particular company may influence more noise traders to buy the stock, artificially inflating its market value.