Why in the long run, noise trading should be safely discarded in traditional asset price modelling?

Noise trading is a method of trading where traders believe they have some inside information which give them better insight than their counterparts and can thus give them an edge in trading. This information may not be the real information and may not give the trader the correct insight he expects to receive. Thus the trader could be looking at only the noise from a signal rather than the signal itself. Thus this trading is called noise trading.

A noise trader does not have a fundamental & technical analysis backing their trading choices and trades based on his beliefs. This can lead to insufficient diversification and oversimplified choices. Thus from the general nature of trading itself, it can yield results which are not better than any random choices. Such a method of trading is usually emotionally driven and it’s not possible to model this behaviour. Thus asset pricing and true value of asset derived from noise trading may not be correct. Moreover, the market prices of assets can be largely distorted from its true value (which can be estimated from any asset pricing model) because f noise trader who generally focus on very few attributes of the asset. This is sometimes considered as idiosyncratic risk in asset pricing models.

Such trading is usually attributes with day traders who focus on short term gains n assets. But as such trader’s consists of a huge part of financial markets; such trading can impact asset pricing.

Also noise trading is also impacted by herding behaviour. Thus when noise traders focuses on the latest trends or styles, herding can lead to financial bubbles which can have large financial impact on the market & economy.

Thus in the long run such trading should be safely discarded to ensure a strong fundamentally strong & stable financial market.