Why so much stock market trading?
one of the important economic puzzles
Economics is a field with some important puzzles. I find that the best answers often come from books that are outside of the mainstream.
Here is one of the puzzles: trading volume in the stock market.
Rational investors would not trade often. If you believe the Efficient Market Hypothesis, then you do not assume that you can outsmart the market. Trading to try to beat the market is a losing proposition. In fact, the overwhelming majority of individual investors do not trade frequently. But trading volume far exceeds anything that a model would predict, assuming rational individuals.
A small minority of individuals account for most of the individual trading. But institutional investors appear to account for more trading than do individuals (reliable data are not easy to come by).
One economic model is that there are “noise traders,” who make trades on the basis of useless or misleading information. Opposite them are market sharks, who buy what the noise traders sell and sell what the noise traders buy.
Does that mean that market professionals are all sharks, who can certainly make money? Absolutely not. And in any case, the model of “noise traders” does not really get us very far in explaining stock market volume.
My introduction to the stock market came from The Money Game, written by financial journalist George J.W. Goodman and published in 1967 under the pseudonym “Adam Smith.” That book’s psychological insights influence my views to this day.
“Smith” in turn credits John Maynard Keynes’ chapters on speculation and long-term expectations in The General Theory. He emphasizes this sentence from Keynes:
The game of professional investment is intolerably boring and over-exacting to anyone who is entirely exempt from the gambling instinct; whilst he who has it must pay to this propensity the appropriate toll.
Economists have paid considerable attention to Keynes, but not to this sentence. The combination of “game” and “gambling instinct” is, I think, the best solution to our puzzle.
As I adapt that framework, I see most of the stock market trading coming from individuals, amateur and professional, who see it as a game and who believe that they are good at it. In a way, this combines two ideas proposed by modern behavioral finance theorists: trading as entertainment, and trading that results from overconfidence. These behavioral finance theories I would argue were anticipated by that sentence from Keynes, as emphasized in The Money Game
The fund managers in The Money Game are a proud, competitive bunch. They are convinced that they have an edge.
I think of these as very masculine traits. While women have come into the world of finance, my framework leads me to suspect that men still account for the majority of active trading.
People who trust active fund managers also must be convinced that they have an edge. But few individuals or professionals, if any, actually have an edge.
People who do not believe that anyone has a reliable edge will refrain from trading. Trading reflects overconfidence in having a reliable edge.
In this framework, most of the stock trading is done by irrational men. But the irrationality does not take the form of a predictable bias. It takes the form of overconfidence that one has found an edge.
We cannot think in terms of the market acting like a single man, rational or otherwise. Market outcomes reflect the bets made by irrational men with many different beliefs and strategies.
The net result is that stock prices cannot be systematically predicted. So the market as a whole is weakly efficient, or weakly rational if you will.
My father contributed to a 401k through his union. He had limited options for choosing funds and the ones involving the stock market were actively managed with the manager taking home like 1% or something. I always thought the union was getting a kickback from the managers.
Those active managers have to trade because doing nothing would call into question their 1%.
Fischer Black's "Noise," written in 1985, which introduced the concept of noise traders, largely avoids the question of why anyone would persist in trading noise. But once we assume that true asset values exist, we commit to introducing informational privilege as the basis for rational trading.
What if they don't?
Hal Varian's "Differences of Opinion and the Volume of Trade ", also 1985, offers a compelling alternative perspective that does not need privileged "informed" traders and the fools who insist on trading on noise. In his model, there are no privileged parties; everybody is mildly rational, mildly mistaken, and there is no true but unobserved value of any asset, only information that gets interpreted and evaluated in a larger economic context.
Black dismisses Varian's view in a footnote in his Noise - that's how I learned about Varian's models.
Black's paper is cited ~5000 times. Varian's 50.