Critique of the Noise System

News which are disseminated by the business press and by financial television usually do not represent “information” in the sense that they could be utilized. They appear as data with a certain content, but in fact, they are for the most part nothing but  noise – empty information particles, which are already contained in stock market prices. Investors who follow such pseudo-information can be considered as noise traders. Their investment decisions are based on data that do not have any actual meaning.

Much ado about nothing? Not at all, since the dependence on empty information particles makes investors more susceptible to mood swings. They follow the vagaries of the market, rumors and, with particularly severe consequences, past performance. They chase after trends because they fallaciously believe that future price developments follow the past. And they make markets more susceptible to fluctuations by evoking nervous overreactions and reinforcing them.

Since the nineties in particular, the volume of news in the media that are related to the capital market has strongly increased. The army of noise traders has seen a millionfold increase in members. Actions of a growing number of private, but also professional investors, are subject to increasing mood swings. Especially in times of stock market boom: Rising prices increase the reach of the business media – and thereby also the noise in the market.

Financial economists argue that noise is actually the precondition for the existence of liquid markets: Stock market transactions are only carried out if the opponents hold different opinions about the future prospects of the relevant investments. These differences of opinion necessarily originate from qualitatively different information – and thus from the existence of noise. A certain “noise level” is therefore indispensible for trading activities to take place.

Only if there is sufficient noise in the market do information holders have an incentive to act. Otherwise, they would have to compete with equally informed market participants, which would significantly reduce the amount of business. In order to avoid this and in order to have sufficient numbers of less well-informed opponents, it is in their interest to install trading platforms, to create financial instruments, to advertise them and to produce noise to cause demand.

From this point of view, it is in the interest of information holders if there are numerous business media, that disseminate pseudo-information with little content, which convey a “sense of market”, although they are basically worthless. If they did not already exist, these market participants would have to invent the media, to make the idea of the markets popular and to gain new investors. It may be an odd coincidence: This is exactly what is observable in practice.

But noise has got more effects: It makes it more difficult to arrive at a clear picture of the market situation. A wall of worthless information obscures the view of the actual economic circumstances: Noise makes market signals ambiguous, an adequate evaluation of investments becomes increasingly difficult – even for “informed” market participants. Noise thus does not only fulfill its “natural” function of generating liquidity in the markets: It makes prices less efficient.

This provides an opportunity for informed investors to take advantage of the mistakes that naive noise traders make under the impression of contaminated news: They are able to anticipate overreactions, which occur due to positive feedback processes – and thereby reinforce them. And they can build up counter-positions, in order to lead prices back to their correct level and separate noise traders from their money in the process.

However, this is not a zero-sum game. For inefficient prices imply an increased susceptiblility to fluctuations, an additional systematic market risk. The unpredictability of prices increases if investors’ behavior is conditioned by noise. Systematic market risks, however, concern all market participants, they cannot be eliminated through counter-measures. The related costs are borne by all market participants as well.

Noise destabilizes. Pseudo-signals obstruct the view of the real economic situation and contribute to the generation of self-reinforcing price dynamics. And they react in an unpredictable way on the economic situation. Part of these pseudo-signals are forecasts of finance gurus, most of the information disseminated by brokerage houses and banks as well as the non-events of the news media.

With the expansion of the noise system, destabilizing forces have increased. The markets are far from reaching a permanent state of equilibrium. The probability of dynamic self-runners increases with growing levels of noise. More than ever, the statement applies that markets may be efficient on the micro level, whereas they can be inefficient on the macro-level. And that they possibly are increasingly inefficient.

There is, of course, the possibility to benefit from more pronounced market fluctuations: Noise traders can obtain higher profits, in ignorance of the risk they are exposed to. Information traders can try to take advantage of the mistakes of the noise traders. Profit and loss are not always accurately distributed between rational and irrational investors. Often, it is hardly possible or even impossible to distinguish between the two.

Potentially, however, the benefit for all is reduced, while the risk increases disproportionately – for everybody. Although the exact level might be difficult to estimate quantatively: From a certain point, the costs of the noise outweigh its benefits, until everyone loses in the end. Noise turns out to be counter-productive on a macroeconomic level, since it leads to a waste of capital.

Excessive noise disturbs the adequate use of resources and undermines trust in the markets. Rational investors are deterred, because they consider the risks to be too high. The others only learn afterwards: When investors have to realize that they suffered damage because their picture of the markets corresponded to an artificial scenery of noise, collective disillusionment is a probable consequence.

Only few actors benefit: Those who profit from an increase in trading volume and higher turnovers of information; and those who successfully bet against uninformed investors, who follow pseudo-information. Many become poorer, only few get the chance to systematically enrich themselves.

Afterword to Thomas Schuster, The Markets and the Media. Business News and Stock Market Movements. Landham, MD: Lexington Books, pp. 97-99.