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Wednesday, February 10, 1999 Published at 17:08 GMT


Truth lost in the noise

Some traders do not care about the true value of stocks

The stock market is doomed to be a roller coaster ride of highs and lows thanks to "sheep" traders who worry more about what others are doing to share prices and not about the true value of the stocks, according to new mathematical research.

Two scientists have created a mathematical model of the stock market, which shows that chaotic ups and downs happen because of the actions of the traders, not because of any real change in the underlying value of the stocks.

This means that share prices will never be predictable, said Thomas Lux, in the Economics department at Bonn University, Germany, speaking to the BBC.

"Our paper is not about prediction. On the contrary, in our model you cannot predict future stock prices, because it depends not only on the changes in the fundamental worth of stocks but also on the unpredictable opinions of traders in the market," he said.

Fundamentals of business

Jeremy Batstone, head of research at NatWest Stockbrokers, told BBC News Online that the research highlights an important truth about the stock market.

"There is a great danger in getting too carried away simply with share price movements. We have been saying that traders need to concentrate less on share price and more on fundamentals of business.

"People can make money on short-term, knee-jerk reactions and there is an element in the City that if you are making money why change it. But investors must try and think beyond that.

"The whole point about buying a share is that you should be interested in the underlying business - you should take as much interest as if you were buying a house or a car."

Noise traders

The model Dr Lux created with Michele Marchesi at the University of Cagliari, Italy, has two types of traders.

  • "Fundamentalists" try and make money by spotting differences between the share price and what the share is genuinely worth based on real-world events.
  • "Noise traders" do not care what the genuine value is - they make their money simply by speculating the rise and fall of share prices.

Noise traders make their money more quickly. But as more join the herd and follow the trend, the share price can be pushed far from its true worth, causing booms or crashes. At that point, fundamentalists step in and bring the share price back towards it underlying, true value.

The model shows that the market gets volatile when the number of traders acting as noise traders gets to a critical proportion.

The research is published in the journal Nature.

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