The Influence of Noise Transactions on Stock Price - Admission/Application Essay Example

The Influence of Noise Transactions on Stock Price compared against the Market Efficiency Hypothesis Fisher Black has described the influence of freelance trading activities in modern stock markets as both a limiting factor in the efficiency of the market, and also a source of potential profits in and of itself. The question of noise in financial markets, as well as noise trading appears potentially representative of an endemic paradox within the systemic functions that underlie stock markets in general. All parties wish for accurate information. To achieve this, all parties needed to understand the possible development of trends within the financial market. In order to identify a trend, there is a presumption that more information is always needed. Therefore, from the perspective of herd psychology the behavior inherent in noise trading, as a result of interest in financial noise becomes a predictable consequence of financial markets. Noise of course in this context refers to low level, seemingly isolated financial trades that may appear to be distinct from large-scale actions by major corporate players. It is logical to suppose that if a trend were to exist, it must do some extent be reflected in noise of transactions at a basal level. However, this contention is theoretically logical – but it also follows that noise transactions would still occur even in the absence of any definitive trend. Yet changes in the market (often dramatic) must inevitably happen, and all parties must identify a bandwagon upon which to place their money if for no other reason than to avoid taking substantial losses, to say nothing of reaping significant profits. Therefore, it becomes logical for certain individuals to provide a service for those seeking information on noise transactions, and this activity, the emergence of which is arguably a predictable assumption for a financial market exhibits the potential to undermine the efficiency of these markets. To explore this potential conflict, it is necessary to discuss a theory described as the efficient market hypothesis. The efficient market hypothesis in essence presumes that financial information must invariably spread rapidly within an unrestricted financial market, and therefore changing prices typically with respect to securities must reflect real value based upon the underlying assumptions of the stock market, and in this manner a self regulating mechanism arises by which inefficiencies will be minimized, and eliminated. But the same assumptions that allow analysts to predict reasonable prices could in this instance work against overall market efficiency. The principal assumption being – as expressed above that all investors will invariably wish to follow a trend. And it is unreasonable to simply rely on luck in the hopes of finding the correct trend. Therefore, the constant desire for inside information concerning stock trends creates a new niche of the noise trader. This creates a new class of capitalist who profits off of the stock market, but not necessarily based upon the positive performance of any particular stock in question. Any sort of activity under any financial climate would therefore contain financial noise, and thus be a potential product for this type of trader. In any economic atmosphere this individual could continue to accumulate revenue. It appears inevitable that this type of meta-investment would develop and become potentially profitable. What is potentially more serious are the projected consequences if this behavior becomes the norm. Ordinarily, the prices in the stock market for any particular stock should be dependent upon real-world information concerning the performance of the entity in question. Yet this information will be influenced by noise. It is not enough to simply make trades based upon the real properties that objectively exist relating to the entity offering the stock in the first place, the investor must tailor their strategies based upon the activities of other investors. If more noise information becomes available, then this will persuade some investors to alter their behavior pertaining to any particular stock. Therefore it appears inevitable that noise trading must factor into the eventual price of the stock. Therefore the markets must second guess themselves, and it is easy under this realization to project departure from true prices representing real-world information with all parties mutually trying to chase after each other. If more traders find it necessary to trade in noise information, it has the potential to enrich the purveyors of this data, and this would seem to encourage both more customers – and therefore more vendors of this information product – all of which must eventually be factored into stock prices. This is an inherent component of market liquidity. But if pricing information and trading choices are dependent upon nonperformance related factors than prices must continue to drift further away from what would be the most efficient values as reflected in real-world performance. The tendencies within the marketplace that motivates investment represent a potential to undermine any hopes of self correction. Those that trade in noise information appear to represent a logical outgrowth of a dynamic stock market, and will in all probability not be trustworthy in terms of controlling sales of this background information – it represents personal profit. However, this form of information itself is not inherently profitable with respect to the success of any particular investment strategy or portfolio. These individuals could profit from trading in noise information, if they were paid direct fees for the privilege, but it does not necessarily imply a greater degree of predictive success consistently. Noise information has the potential to provide modest advantages, but within a definite margins for error. Consistent profit cannot be guaranteed through the use of this information – because sometimes noise really is just noise. The challenge for these individuals, as is the case for all investors is figuring out when the baseline activity actually means something. Such estimations would be made all the more difficult as an indirect consequence of the noise itself. To the extent that noise trading influences prices of the stocks in question, though stocks will continue to deviate in value from a hypothetical price based solely upon real-world activity; which is an assumption of the efficient market hypothesis. Therefore, this tendency towards drift or inflation away from a purely performance driven value of the stock adds another variable of complexity for anyones attempts to project a genuine trend. The noise information trader must therefore take into account available information about the real value of the stocks in question, a calculation of presumed opinions about that real value, and further calculations concerning price inflating consequences of other noise information traders who may be making the same set of calculations themselves. A strong believer in the efficient market hypothesis might offer the counter argument that this noise inflation is ultimately irrelevant with respect to long-term prices. If one assumes that the market is efficient, and will correct for inefficiency then natural limitations will exist concerning the degree of inflation possible through unwarranted assumptions. Therefore, irrational enthusiasm may develop based upon widespread presumptions or misconceptions, but that market corrections will become inevitable. It is arguable that the consequences from noise trading could be accounted for by the principle of the random walk. In this case, it can be presumed that most fluctuations in price are due to random forces, but that the ultimate expedient of profitability based on real world information must inevitably force the market to snap back. An efficient market will occur, one way or another. This assertion is potentially justified through any examination of swift market corrections, what may be termed the bubble bursting. Rapid deflations of overinflated stocks. Such as the great stock market crash leading to the Great Depression, or the more distant Dutch tulip bulb craze that afflicted the first stock markets in the 17th century, in which case the price of a commodity steadily rose until a limitation was reached after which the market collapsed rapidly (Dash, 2001). These examples are representative of limitations in presumed value, roughly analogous to a dog walking on a leash but shifting course randomly to investigate a wide range of objects, but always restricted by the length of the leash and the direction of his owner. The range of causative factors influencing this interesting in price is not dependent upon any singular factor. A multiplicity of causes lead to random wobbles in pricing and stock performance, but the assumption of an efficient market is that real values exist beyond which deviation is not sustainable. And so any value presumptions not undergirded by real performance are eventually doomed to fail, the question becomes whether the individual investor can take advantage of these corrections when they invariably happen? Noise trading increases market volatility, but eliminating or reducing it is not realistic. A free market must include the possibility of noise trading, without which the total volume of trading in individual assets would decrease. Investment is possible for some individuals without specific trading in the individual shares of the company in question, in the form of mutual funds or various forms of futures or securities. But this is unlikely due to the limitations this would place on investment options, and there will always be certain parties willing to accept greater degrees of risk. However, in order to restrict noise trading, it would be necessary to somehow prohibit trade in the individual shares of company assets, and in that case, there would be no value to motivate money markets, mutual funds, or any other higher order options - no way to efficiently price then. In that situation, the efficient market hypothesis could not function in any event as there would be no obvious way to determine or change prices. This is a fact reminiscent of a Keynesian doctrine that temptation and risk are integral components motivating most investments in the first place. And without them, there would be far less wealth available for most stock markets upon which to make rational projections. Noise trading has the potential to stimulate its own profitability: if noise trading increases, then that information becomes more valuable in trade - but this is a consequence of the fact that the prices are influenced by more noise. But other traders informed by research will employ more sophisticated methods in order to avoid being on the wrong side of a financial bubble burst, this will mean a more sensible evaluation of the real performance behind corporate assets. But as a consequence of the liquidity of the market place which allows for noise trading, so-called information trading does not always yield reliable profits on a consistent basis. Moreover, the lines may blur between technical information and noise trading – further obscuring the distinction between who is a sophisticated trader, and who simply traffics in noise. But the balancing influence of real information will act as the leash, keeping the wandering dog from straying too far from the path. This permits analysts to make a distinction between price and value for a particular commodity. Realistic information driven by performance determines the value, but financial noise and seemingly random trading activities cause deviation in price from actual value. Yet this market liquidity appears to be the most reliable means at present to express that value. And so both metrics depend upon the other – yet the influence of each metric makes it impossible to generate an informed investment strategy based only upon either one. Real values of commodities will eventually limit price inflation (or deflation) as a result of noise. Yet the presence of noise will destabilize expert projections on how a stock should perform based upon a realistic determination of its value. But in comparing unregulated trading activities with sophisticated calculations of worth there are nonetheless logical axioms that can be derived in the midst of market uncertainties. The tendency of the dog to wonder from the path within the confines of his owners leash can be equated with market volatility. But volatility by definition – is not constant. But it is possible to assert that volatility of price within the short term will represent a much greater variation than the volatility of value. Since value is dependent upon real-world performance of financial assets, it is dependent upon forces not subject to fear or presumption. Both value and noise must change over time, but noise must be far more variable. But the business of investing is dependent upon these human emotions which are simultaneously not bound by pure factual assessments, yet remain the driving force behind what those facts will eventually state concerning commodities. This allows the analyst to describe a series of common misconceptions contributing to noise, and driving the behavior of short-term traders. One inevitable logical fallacy could be characterized as post hoc ergo proctor hoc, which is a tendency to perceive to events as related if one happens to follow the other – when in reality a coincidence is highly probable. It feels natural to assume that an influential event for the market must therefore be the cause of another event that occurs immediately thereafter. But this is not necessarily true. In addition, everyone knows that supply and demand correlate with one another and control price, but there are other unobserved factors that must influence the interplay within the economy that ultimately controls demand. Black makes the argument that in order to predict demand, wealth becomes an essential factor. But wealth in an absolute sense may be invisible. The richest individuals are likely to remain rich by not spending everything they could whenever they can. Wealth has the potential to influence need, and by extension demand. But it is difficult to quantify wealth that is not being actively used in purchasing or investing. It may largely depend upon net worth as a function of property, but this may not reflect absolute economic potential with respect to patent cash reserves, or advantages in human resources or other assets. True wealth may not be limited to a real estate dollar value of an individuals property holdings. It is also worthwhile to summarize the assumptions that drive the hypothesis of market efficiency: 1.) Market volatility is greater for price compared with value. 2.) A limitation exists beyond which price volatility can not surpass. 3.) A long-term analysis will find that markets will generate a self correcting mechanism for efficiency by nature. However, in comparing the consequences of value research and noise trading, it is possible to conclude again that real values of commodities are ultimately dependent upon the process of market volatility as it pertains to the trading of individual stocks. The challenge is predicting the direction of that volatility. To this end, it seems natural for investors to grasp at any clue that might hold promise. As a result, it is entirely predictable that investors will jump to conclusions whatever dramatic events follow each other. While it is certainly a possibility that a cascade of changes will result from any shift in the marketplace, but in order to be absolutely certain it will be necessary to possess all relevant facts. And for practical purposes, whether or not an analyst has all relevant facts is unknowable until after the fact. But since it is not possible to give a reliable account of every potential factor influencing every relevant market shift the most logical decision is not always the most profitable. Under most circumstances, it appears that the best and analyst can do is simply compile a list of observable influences, and hedge his or her bets against the unobservable influences. But noise trading appears to be the most viable option in the minds of traders by way of accounting for what is presently unknowable. References Black, F. 1986. The Journal of Finance, Vol. 41, No. 3, Papers and Proceedings of the Forty-Fourth Annual Meeting of the America Finance Association, New York, New York, December 28-30, 1985. (Jul., 1986), pp. 529-543. Dash, M., 2001. Tulipomania: The Story of the Worlds Most Coveted Flower & the Extraordinary Passions It Aroused. Broadway Books, 2001. Read More