Behavioral Finance

CHAPTER 5

The Shleifer Model of Noise Trading

An article published in 1990 provided the first model of a financial market that squarely confronted both parts of the noise trader agenda:

1. Noise trader activity should be systematic.

2. Noise traders should be profitable for a significant period of time.1

In this chapter, we will refer to this model as the Shleifer model, though there were four authors in all. The article was later reprinted in a collection of papers by Andrei Shleifer,2 and thus the model has become more widely associated with Shleifer's name than with his co-authors.

The Shleifer model incorporates two types of traders: rational traders and noise traders. The systematic behavior of noise traders is assumed. The first key result is that, under certain circumstances, two fundamentally identical assets can trade at different prices, and that the price differential can widen over time. The second key result is that under certain circumstances, noise traders can make money. It is even possible in the model for the rational traders to go bust.

The Shleifer model has a number of ingenious devices that enable the model to forecast the possibility of noise trader financial success, but nothing more striking than the definition of the assets. The assets are much like our hardball and softball described in the previous chapter. The assets differ mainly in name but are fundamentally the same asset. So can their prices differ? Yes, in the Shleifer model, the prices of the ...