A noise trader is an individual who trades based on incomplete or inaccurate data, often trading irrationally. Noise traders often make trades based on hype or rumor, rather than on solid technical or fundamental analysis or professional advice.
The impact of noise traders can be significant. They cause the market to artificially react to their trades and can send prices and stock movements surging in one direction or another, even if all other traders act in a rational way.
Noise traders are usually linked to high volume trading days. They typically end up overinflating securities during bullish periods and excessively deflating them during bearish periods. In most cases, noise traders are investors without a professional background in trading.
Noise traders are typically non-professional individuals who act illogically, using incomplete or inaccurate data to make trades.
It is estimated that there around 50 million self-directed, non-professional traders today, with the number of operating, professional traders being closer to only two million.
Noise traders cause the market to diverge from its normal patterns; they likely played a major role in the housing market crash of 2007-2008.
A Surplus of Noise Traders
The Bureau of Labor Statistics (BLS) reports around 2.8 million professional investors in the market today. On the other hand, the number of non-professional traders in the market today, as discussed above, is estimated at somewhere around 50 million, boosted by the emergence of self-directed trading platforms.
The incredibly popular TD Ameritrade reported a 60% user growth from 2007 to 2017. Another popular platform – Robinhood – saw its user count grow to four million in one year. While not all of the users are conducting their own trades, many are.
What do the numbers above actually mean? It means that a substantial part of the trading population is made up of noise traders – inexperienced or non-professional traders. The individuals likely act on a whim, making trades based on things they’ve overheard, hunches they have, or other illogical information that doesn’t make for solid trades.
As discussed above, the practice makes it more difficult for logical, professional traders and can negatively affect the market as a whole.
The Damaging Impact of Noise Traders
Even if they are one-time traders, they can still cause an impact on the market. Take, for example, the surge in self-directed traders right around 2007. It was the primary time during which trading reached unacceptable levels regarding the housing market, which subsequently crashed hard in 2008.
There are about a dozen “story stocks” that boomed and subsequently bust over the past 20 years. They include the tech bubble, or the “dot com bust.” The Efficient Market Hypothesis (EMH) conceded the existence of noise traders long ago, but also undermined the severity of their impact.
Based on the sheer number of noise traders – which spiked in the past two decades – and the coinciding number of “boom and bust” story stocks, it’s evident that noise traders exert more of an impact than the EMH implies.