Market Noise
Noise in finance refers to volatility generated by market participants with imperfect information, not driven by fundamentals; it includes non-informational order flow (liquidity/hedging needs, constraints, mechanical rebalancing), sentiment and attention shocks, and misinterpretation or overreaction to signals, all of which can push prices away from intrinsic value.
In reality, prices reflect both the asset’s intrinsic value, as well as noise due to noise trading, which is trading on noise as if it were information. As such, noise is defined in contrast to information: it is what makes observations imperfect and keeps investors from cleanly inferring expected returns or fundamentals.
Noise trading happens because extracting information from a noisy environment is hard, so investors can mistake noise for signal. Reasons noise trading arises include:
- Overconfidence (overprecision): investors overestimate the precision of their own signals (and/or underestimate others’), so they put too much weight on the noisy part of what they observe and end up trading “on noise.”
- Noise is required for liquidity: without noise traders, there may be very little trade, because purely informational trade tends to get competed away (no-trade logic). Noise trading supplies volume and makes markets liquid.
- Limits to arbitrage: even if some investors suspect prices contain noise, taking larger positions increases risk; it is hard to tell skill from luck and hard to know if one is trading on information or noise, so information trading does not eliminate noise trading.
- Social forces amplify noise: in fast, crowded markets, communication frictions and limited trust/relationships can fragment trading into cliques, producing dispersion in quotes and higher volatility even with more participants.