Noise Trader Risk in Financial Markets J.Bradford De Long Harvard University and National Bureau of Economic Research Andrei Shleifer University of Chicago and National Bureau of Economic Research Lawrence H.Summers Harvard University and National Bureau of Economic Research Robert J.Waldmann European University Institute We present a simple overlapping generations model of an asset mar- ket in which irrational noise traders with erroneous stochastic beliefs both affect prices and earn higher expected returns.The unpredict- ability of noise traders'beliefs creates a risk in the price of the asset that deters rational arbitrageurs from aggressively betting against them.As a result,prices can diverge significantly from fundamental values even in the absence of fundamental risk.Moreover,bearing a disproportionate amount of risk that they themselves create enables noise traders to earn a higher expected return than rational inves- tors do.The model sheds light on a number of financial anomalies, including the excess volatility of asset prices,the mean reversion of stock returns,the underpricing of closed-end mutual funds,and the Mehra-Prescott equity premium puzzle. We would like to thank the National Science,Russell Sage,and Alfred P.Sloan foundations for financial support.We have benefited from comments from Robert Barsky,Fischer Black,John Campbell,Andrew Caplin,Peter Diamond,Miles Kimball, Bruce Lehmann,Charles Perry,Robert Vishny,Michael Woodford,and especially from Kevin M.Murphy and Barry Nalebuff. [Journal of Polncal Economy,1990.vol.98,no.4] 1990 by The University of Chicago.All rights reserved.0022-3808/90/9804-0004$01.50 703