Noise trading, the law of large numbers and the 2008 ‘Great Recession’

Financial markets are driven by different types of investors, either the sophisticated, educated and rational investors or the uneducated and irrational investors in different forms and degrees.  Traders that trade on noise rather than on the correct market signal, have been formerly defined by Fischer Black, (1965),  as ‘noise traders’ as those stock traders that do not base their decisions of buy , sell or hold on the rational analysis of economic fundamentals but on other criteria, such as mood, fashion, sunspots or other fads. 
The existence of a large number of noise traders may explain why, on the one hand, market prices may err away from their fundamentals and for very long periods of time, enough time to drive out rational arbitrageurs from the market.  It may also explain why, in order not to be considered a fool, you better behave like one and follow the irrational crowds, in order not to lose out and be ejected from your trading seat.  At the end of the day, markets are left out with a larger proportion of crazy fellows that drive the market erratically, further away from its fundamentals, until reality strikes back with a bang.  Once the markets self-correct, it might be too late and too big to be saved, because the damage is too big, as we have seen recently in what has now been justly labeled the 2008 ‘Great Recession’.  The real and present danger of noise trading risk is big.  The fact that it is not being addressed at all in today’s international and national financial reform agenda, is a big mistake, by Marwan Elkhoury.  (Download the article here).
 

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