Digitised version produced by the EUI Library and made available online in 2020.

Analyses of rational speculation usually presume that it dampens fluctuations caused by “noise” traders. This is not necessarily the case if noise traders follow positive‐feedback strategies—buy when prices rise and sell when prices fall. It may pay to jump on the bandwagon and purchase ahead of noise demand. If rational speculators' early buying triggers positive‐feedback trading, then an increase in the number of forward‐looking speculators can increase volatility about fundamentals. This model is consistent with a number of empirical observations about the correlation of asset returns, the overreaction of prices to news, price bubbles, and expectations.

Recent empirical research has identified a significant amount of volatility in stock prices that cannot easily be explained by changes in fundamentals; one interpretation is that asset prices respond not only to news but also to irrational “noise trading.” We assess the welfare effects and incidence of such noice trading using an overlapping‐generations model that gives investors short horizons. We find that the additional risk generated by noise trading can reduce the capital stock and consumption of the economy, and we show that part of that cost may be borne by rational investors. We conclude that the welfare costs of noise trading may be large if the magnitude of noise in aggregate stock prices is as large as suggested by some of the recent empirical litrature on the excess volatility of the market.

The authors 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.