The ABC of noise traders

Herbert Simon is famous for developing the concept of ‘satisficing’ which eventually won him the Nobel Prize in Economics 1976. Essentially, satisficing describes a behaviour where a decision-maker is confronted with an overwhelming amount of information. The decision-maker then goes through the information until a threshold is crossed that makes him or her sufficiently certain of the outcomes of a decision. Based on this satisfying insight, the decision is then made.

Now assume you are a day trader. You have a long list of companies you like to invest in, and you are fast and loose with your money. You buy a stock one day and sell it a couple of days or even hours later. In other words, you are the classic noise trader of economics textbooks.

Now assume that you have to digest new information like the actions of a central bank or earnings reports. Surely, you would focus on your biggest positions or the stocks most likely to be affected by the news before moving on to other stocks. Surely, nobody would just go through the list of names alphabetically and then stop when they get exhausted or feel they have done enough.

Surely.

If you ask Magnus Blomkvist and Okke Bergers from EDHEC Business School they would disagree. They looked at the monthly returns of US listed companies between 1999 and the end of 2021. Then they measured the idiosyncratic volatility of each stock, i.e. the volatility in share prices that cannot be explained by common factors like the market factor, valuations, etc.

And they found that the idiosyncratic volatility of stocks who show up in the top 5% of alphabetically ordered stocks in an index or market was about 2.0 to 4.5% higher than for the other 95% of stocks. Looking at the current constituents of the S&P 500 that would be anything from 3M Corporation to Amazon.

Obviously, this could just be a statistical artefact of the data, so they also looked at companies that changed their names. They found almost 2,000 companies that changed their names in such a way that hey dropped from the first 5% to something in the bottom 90% or vice versa. And they find that while a company belongs to the first 5% t 10% of the alphabetical list, the idiosyncratic volatility of the share price is 7% to 8% higher than when they don’t.

Furthermore, when investor sentiment is high and retail trading volume is high, this alphabetical impact on idiosyncratic volatility is more pronounced, further adding to the suspicion that it is noise traders who cause this volatility.

I mean, I never had any respect for amateur day traders, but this is something else. Apparently, when these guys do their work, they never get to Zoetis or Zions Bancorp and thus create less noise in these stocks than their alphabetical forerunners.

Sometimes, the world is even crazier than I thought it was.