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RFS Advance Access originally published online on January 26, 2009
Review of Financial Studies 2009 22(6):2275-2302; doi:10.1093/rfs/hhn102
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© The Author 2009. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oxfordjournals.org.

How Noise Trading Affects Markets: An Experimental Analysis

Robert Bloomfield
Johnson Graduate School of Management, Cornell University

Maureen O’Hara
Johnson Graduate School of Management, Cornell University

Gideon Saar
Johnson Graduate School of Management, Cornell University

Send correspondence to Maureen O'Hara, Johnson Graduate School of Management, Sage Hall, Cornell University, Ithaca, NY 14853; telephone: (607)-255-3645; fax: (607)-255-5993; E-mail: rjb9{at}cornell.edu

JEL Classification: D03, G12, G14


  Abstract

We use a laboratory market to investigate the behavior of traders who lack informational advantages and have no exogenous reason to trade. We find that these uninformed traders behave largely as irrational contrarian "noise traders," trading against recent price movements to their own detriment. The uninformed traders provide some benefits to the market: increasing market volume and depth, while reducing bid-ask spreads and the temporary price impact of trades. However, their noise trading also diminishes the ability of market prices to adjust to new information. A securities transaction tax reduces uninformed trader activity, but it reduces informed trader activity by approximately the same amount; as a result, the tax does not alter the impact of noise trading on the informational efficiency of the market.

We would like to thank an anonymous referee, Matt Spiegel (the editor), Lucy Ackert, Joel Hasbrouck, Shimon Kogan, Wei Xiong, Halla Yang, and seminar participants at the NBER, New York University, Texas A&M, and the American Finance Association Meetings (Boston) for helpful comments. Financial support for this project was obtained from New York University's Salomon Center for the Study of Financial Institutions.


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