Noise Traders and Why Prices Can Be Wrong
Economics has a rule that sounds so obvious it barely needs saying. If two things are identical, they should have the same price. If they don’t, someone will buy the cheap one and sell the expensive one until prices meet in the middle. Easy. Done. Move on.
But here’s the thing. In real markets, this breaks all the time. And Chapter 4 of Burton and Shah’s book explains why, starting with a concept called the law of one price and ending with noise traders who mess everything up.
The Law of One Price
The law of one price is simple. Two identical things should cost the same. If apples cost $1 at one store and $2 at another, people will buy from the cheap store. The expensive store will have to lower prices. Competition pushes prices together. This is called arbitrage, and it’s one of the most basic ideas in economics.
But the key word here is “identical.” What counts as identical?
The book uses a great example. Imagine a factory that makes baseballs. Every second ball off the line gets labeled “hardball.” The rest get labeled “baseball.” They’re physically the same. Same weight, same size, same everything. Just different labels.
Can they have different prices?
Traditional economics says no. The efficient market hypothesis (EMH) says all information about these items is the same, so prices must be the same.
But a behavioral economist might say: actually, maybe. Different labels can lead to different prices in people’s heads, even when the products are physically identical.
Fungibility Is the Key
There’s a fancy word for this situation: fungibility. It means you can convert one thing into another freely. If you have a machine that turns baseballs into hardballs and back, one for one, no cost, then prices can never stay apart for long. You just buy the cheap one, convert it, sell it as the expensive one. Profit.
Financial markets have real examples of fungibility. A gold futures contract is basically another way of owning gold. If you hold it until delivery, you get actual gold. Options and futures can often be converted into the underlying asset. So their prices stay tightly linked.
But what if things are not fungible? What if the baseballs have “baseball” stamped permanently on them and the hardballs have “hardball” stamped on them? No conversion machine. Then the arbitrage breaks down. Someone might just prefer “hardballs” and pay more for them. And there is nothing mechanical to force prices together.
Royal Dutch Shell: A Real World Example
The most famous real-world case is Royal Dutch and Shell. These were two stocks representing ownership in the same company. Royal Dutch (a Netherlands company) was entitled to 40% of the company’s earnings. Shell (a British company) got 60%. So three shares of Royal Dutch should equal the price of two shares of Shell. Same earnings, same company.
But they almost never traded at that ratio. The prices would diverge, sometimes by a lot, and stay apart for a long time.
Why? Because they were not fungible. You could not take three shares of Royal Dutch and convert them into two shares of Shell. There was no conversion machine. You could only sell one and buy the other on the open market. And the market was not cooperating.
This is not some obscure corner case. This was one of the biggest oil companies in the world. And still, the law of one price didn’t hold.
So Who’s Buying at the Wrong Price?
If prices are wrong, somebody has to be making them wrong. Someone is paying too much or selling for too little. These people have a name: noise traders.
But first, the traditional view. Milton Friedman argued that these kinds of “wrong” traders would just lose money. If speculators push prices away from where they should be, they’re essentially buying high and selling low. Smart traders will take the other side and pocket the profit. Eventually, the dumb money runs out and prices go back to normal.
Eugene Fama added another argument. Even if some people are irrational, their irrationality might cancel out. Some people irrationally love baseballs, some irrationally love hardballs. On average, it washes out. Prices stay roughly correct.
These are good arguments. But they have holes.
What Are Noise Traders?
Fischer Black, one of the guys who created the Black-Scholes option pricing formula, gave a presidential address to the American Finance Association in 1985. The title was just one word: “Noise.”
His definition of noise trading: “trading on noise as if it were information.”
A noise trader is somebody who trades for reasons that have nothing to do with the actual value of the asset. Maybe it’s a tax seller dumping stocks at year-end without looking at price. Maybe it’s a grandmother buying Disney stock for her grandkid because the kid likes Disney movies. Maybe it’s someone who read a hot tip on social media and YOLO’d in.
The point is they’re not analyzing the company. They’re not looking at earnings, cash flow, or competitive position. They’re trading on something else. Something that is not real information. That something is noise.
Black’s key quote: “Noise makes financial markets possible, but also makes them imperfect.”
He actually thought this was fine. He estimated markets are efficient about 90% of the time. But that other 10% is where things get interesting.
The Noise Trader Agenda
Here’s where it gets important. Just saying “some people are irrational” is not enough to break the EMH. The book lays out two conditions that must be met:
1. Noise trader behavior must be systematic. Irrational traders can’t just randomly cancel each other out. There has to be herd behavior. A big group of noise traders has to push in the same direction at the same time. If half are too bullish and half are too bearish, the effects cancel and the EMH survives.
2. Noise traders need to survive economically. If noise traders just lose all their money quickly, they don’t matter. They need to stick around. They need to make money at least sometimes. Otherwise, as Friedman said, they’re just cannon fodder for the smart traders.
Both conditions need to be met for noise traders to be a real problem for the efficient market story.
Why Smart Money Can’t Always Fix Things
This is the part most people don’t think about. Even if you know prices are wrong, fixing them is not free and not safe.
Take the Royal Dutch/Shell case. You see that one is cheap relative to the other. Great. You buy the cheap one, short the expensive one, and wait for prices to converge. But what if they don’t converge? What if they diverge even more? You’re now losing money on both sides of your trade. Your broker wants more collateral. Your investors are panicking. You might be forced to close the position at a loss before prices ever correct.
This is the limit to arbitrage. Being right about fundamental value does you no good if you run out of money before the market agrees with you. And if noise traders keep piling in on the wrong side, they can keep prices wrong longer than you can stay solvent.
What This Means for You
Chapter 4 sets up the battlefield. Traditional finance says prices are right because smart money fixes any mistakes. Behavioral finance says not so fast. When things are not easily convertible, when noise traders herd together, and when arbitrage has real costs and risks, prices can stay wrong for a long time.
This is not just academic theory. It affects every market. Stocks, bonds, crypto, real estate. Anywhere where people trade on feelings, tips, or trends instead of real information, you have noise. And noise has consequences.
The next chapter will get into a specific model by Shleifer and others that shows how noise traders can actually survive and even prosper. That is where the real challenge to efficient markets begins.
Previous: Before Behavioral Finance - Wall Street Folklore and Value Investing