Person:

Summers, Lawrence

Analyses of the role of rational speculators in financial markets usually presume that such investors dampen price fluctuations by trading against liquidity or noise traders. This conclusion does not necessarily hold when noise traders follow positive-feedback investment strategies buy when prices rise and sell when prices fall. In such cases, it may pay rational speculators to try to jump on the bandwagon early and to purchase ahead of noise trader demand. If rational speculators' attempts to jump on the bandwagon early trigger positive-feedback investment strategies, then an increase in the number of forward-looking rational speculators can lead to increased volatility of prices about fundamentals.

The authors present a model of portfolio allocation by noise traders with incorrect expectations about return variances. For such misperceptions, noise traders who do not affect prices can earn higher expected returns than rational investors with similar risk aversion. Moreover, such noise traders can come to dominate the market in that the probability that they eventually have a high share of total wealth is close to one. Noise traders come to dominate despite their taking of excessive risk and their higher consumption. The authors conclude that the case against their long-run viability is not as clear-cut as is commonly supposed.

We present a simple overlapping generations model of an asset market in which irrational noise traders with erroneous stochastic beliefs both affect prices and earn higher expected returns. The unpredictability of noise traders' beliefs creates a risk in the price of the asset that deters rational arbitrageurs from aggressively betting against them. As a result, prices can diverge significantly from fundamental values even in the absence of fundamental risk. Moreover, bearing a disproportionate amount of risk that they themselves create enables noise traders to earn a higher expected return than rational investors do. The model sheds light on a number of financial anomalies, including the excess volatility of asset prices, the mean reversion of stock returns, the underpricing of closed-end mutual funds, and the Mehra-Prescott equity premium puzzle.