Please provide a two-page summary of the Noise article by the due date.
Noise THE JOURNAL OF FINANCE. VOL. XLI, NO.3. JULY 1986 Noise FISCHER BLACK* ABSTRACT The effects of noise on the world, and on our views of the world, are profound. Noise in the sense of a large number of small events is often a causal factor much more powerful than a small number of large events can be. Noise makes trading in financial markets possible, and thus allows us to observe prices for financial assets. Noise causes markets to be somewhat inefficient, but often prevents us from taking advantage of inefficiencies. Noise in the form of uncertainty about future tastes and technology by sector causes business cycles, and makes them highly resistant to improvement through government intervention. Noise in the form of expectations that need not follow rational rules causes inflation to be what it is, at least in the absence of a gold standard or fixed exchange rates. Noise in the form of uncertainty about what relative prices would be with other exchange rates makes us think incorrectly that changes in exchange rates or inflation rates cause changes in trade or investment flows or economic activity. Most generally, noise makes it very difficult to test either practical or academic theories about the way that financial or economic markets work. Weare forced to act largely in the dark. I USE THE WORD "noise" in several senses in this paper. In my basic model of financial markets, noise is contrasted with information. People sometimes trade on information in the usual way. They are correct in expecting to make profits from these trades. On the other hand, people sometimes trade on noise as if it were information. If they expect to make profits from noise trading, they are incorrect. However, noise trading is essential to the existence of liquid markets. In my model of the way we observe the world, noise is what makes our observations imperfect. It keeps us from knowing the expected return on a stock or portfolio. It keeps us from knowing whether monetary policy affects inflation or unemployment. It keeps us from knowing what, if anything, we can do to make things better. In my model of inflation, noise is the arbitrary element in expectations that leads to an arbitrary rate of inflation consistent with expectations. In my model of business cycles and unemployment, noise is information that hasn't arrived yet. It is simply uncertainty about future demand and supply conditions within and across sectors. When the information does arrive, the number of sectors where there is a good match between tastes and technology is an index of economic activity. In my model of the international economy, changing relative prices become noise that makes it difficult to see that demand and supply * Goldman, Sachs & Co. I am grateful for comments on earlier drafts by Peter Bernstein, Robert Merton, James Poterba, Richard Roll, Hersh Shefrin, Meir Statman, Lawrence Summers, and Laurence Weiss. 529 530 The Journal of Finance conditions are largely independent of price levels and exchange rates. Without these relative price changes, we would see that a version of purchasing power parity holds most of the time. I think of these models as equilibrium models. Not rational equilibrium models, because of the role of noise and because of the unconventional things I allow an individual's utility to depend on, but equilibrium models nonetheless. They were all derived originally as part of a broad effort to apply the logic behind the capital asset pricing model to markets other than the stock market and to behavior that does not fit conventional notions of optimization. These models are in very different fields: finance, econometrics, and macro- economics. Do they have anything in common other than the use of the word "noise" in describing them? The common element, I think, is the emphasis on a diversified array of unrelated causal elements to explain what happens in the world. There is no single factor that causes stock prices to stray from theoretical values, nor even a small number of factors. There is no single variable whose neglect causes econometric studies to go astray. And there is no simple single or multiple factor explanation of domestic or international business fluctuations. While I have made extensive use of the work of others, I recognize that most researchers in these fields will regard many of my conclusions as wrong, or untestable, or unsupported by existing evidence. I have not been able to think of any conventional empirical tests that would distinguish between my views and the views of others. In the end, my response to the skepticism of others is to make a prediction: someday, these conclusions will be widely accepted. The influence of noise traders will become apparent. Conventional monetary and fiscal policies will be seen as ineffective. Changes in exchange rates will come to provoke no more comment than changes in the real price of an airline ticket. Perhaps most important, research will be seen as a process leading to reliable and relevant conclusions only very rarely, because of the noise that creeps in at every step. If my conclusions are not accepted, I will blame it on noise. I. Finance Noise makes financial markets possible, but also makes them imperfect.' If there is no noise trading, there will be very little trading in individual assets." People will hold individual assets, directly or indirectly, but they will rarely trade them. People trading to change their exposure to broad market risks will trade in mutual funds, or portfolios, or index futures, or index options. They will have 1 The concept of noise trading and its role in financial markets that I develop in this paper was developed through conversations with James Stone. 2 Jaffe and Winkler [31) have a model where the traders who make speculative markets stable are those who trade to adjust their risk level or who misperceive their forecasting ability or who trade for reasons other than maximizing expected return for a given level of risk. Figlewski [23) has a model where there are two types of traders who differ in forecasting ability. Since neither kind of trader explicitly takes into account the information the other kind of trader has, each is to some degree trading on noise. Noise 531 little reason to trade in the shares of an individual firm," People who want cash to spend or who want to invest cash they have received will increase or decrease their positions in short term securities, or money market accounts, or money market mutual funds, or loans backed by real estate or other assets. A person with information or insights about individual firms will want to trade, but will realize that only another person with information or insights will take the other side of the trade. Taking the other side's information into account, is it still worth trading? From the point of view of someone who knows what both the traders know, one side or the other must be making a mistake." If the one who is making a mistake declines to trade, there will be no trading on information. In other words, I do not believe it makes sense to create a model with information trading but no noise trading where traders have different beliefs and one trader's beliefs are as good as any other trader's beliefs. Differences in beliefs must derive ultimately from differences in information," A trader with a special piece of information will know that other traders have their own special pieces of information, and will therefore not automatically rush out to trade. But if there is little or no trading in individual shares, there can be no trading in mutual funds or portfolios or index futures or index options, because there will be no practical way to price them. The whole structure of financial markets depends on relatively liquid markets in the shares of individual firms. Noise trading provides the essential missing ingredient. Noise trading is trading on noise as if it were information. People who trade on noise are willing to trade even though from an objective point of view they would be better off not trading. Perhaps they think the noise they are trading on is information. Or perhaps they just like to trade." With a lot of noise traders in the market, it now pays for those with information to trade. It even pays for people to seek out costly information which they will then trade on. Most of the time, the noise traders as a group will lose money by trading, while the information traders as a group will make money. 3 Rubinstein [54], Milgrom and Stokey [50), and Hakansson, Kunkel, and Ohlson [30) show in a state preference world that differences in information may affect prices without causing people to trade. Grossman and Stiglitz [28) show that there may be no equilibrium when rational investors trade in the market portfolio. Grossman [27) shows the same thing for a world with trading in individual assets. Diamond and Verrecchia [21) redefine a rational expectations equilibrium in the presence of noise and show the conditions under which their equilibrium exists. In Tirole's model [61], "speculation" relies on inconsistent plans, and thus is ruled out by rational expectations. Kyle [36), [37), [38) and Grinblatt and Ross [26) look at quite different models of equilibrium where traders have market power. Kyle specifically examines the effects of changing the number of noise traders in both kinds of equilibrium. 4 This assumes that the traders start with well diversified portfolios. In Admati [1), the traders start with suboptimal portfolios of assets. 5 Varian [64) distinguishes between "opinions" and "information." He says that only differences in opinions will generate trading. In the kind of model he is working with, I think that differences of opinion will not exist. 6 In Laffont [39), traders gather costly information because it has direct utility for reasons other than trading. Once they have it, they trade on it. Ifpeople start with efficient portfolios, though, even the arrival of free information may not make them want to trade. We may need to introduce direct utility of trading to explain the existence of speculative markets. 532 The Journal of Finance The more noise trading there is, the more liquid the markets will be, in the sense of having frequent trades that allow us to observe prices. But noise trading actually puts noise into the prices. The price of a stock reflects both the information that information traders trade on and the noise that noise traders trade on. As the amount of noise trading increases, it will become more profitable for people to trade on information, but only because the prices have more noise in them. The increase in the amount of information trading does not mean that prices are more efficient. Not only will more information traders come in, but existing information traders will take bigger positions and will spend more on information