THE JOURNAL OF FINANCE.VOL.XLI,NO.3.JULY 1986 Noise FISCHER BLACK* ABSTRACT The effects of noise on the world,and on our views of the world,are profound.Noise in the sense of a large number of small events is often a causal factor much more powerful than a small number of large events can be.Noise makes trading in financial markets possible,and thus allows us to observe prices for financial assets.Noise causes markets to be somewhat inefficient,but often prevents us from taking advantage of inefficiencies. Noise in the form of uncertainty about future tastes and technology by sector causes business cycles,and makes them highly resistant to improvement through government intervention.Noise in the form of expectations that need not follow rational rules causes inflation to be what it is,at least in the absence of a gold standard or fixed exchange rates.Noise in the form of uncertainty about what relative prices would be with other exchange rates makes us think incorrectly that changes in exchange rates or inflation rates cause changes in trade or investment flows or economic activity.Most generally,noise makes it very difficult to test either practical or academic theories about the way that financial or economic markets work.We are forced to act largely in the dark. I USE THE WORD "noise"in several senses in this paper. In my basic model of financial markets,noise is contrasted with information. People sometimes trade on information in the usual way.They are correct in expecting to make profits from these trades.On the other hand,people sometimes trade on noise as if it were information.If they expect to make profits from noise trading,they are incorrect.However,noise trading is essential to the existence of liquid markets. In my model of the way we observe the world,noise is what makes our observations imperfect.It keeps us from knowing the expected return on a stock or portfolio.It keeps us from knowing whether monetary policy affects inflation or unemployment.It keeps us from knowing what,if anything,we can do to make things better. In my model of inflation,noise is the arbitrary element in expectations that leads to an arbitrary rate of inflation consistent with expectations.In my model of business cycles and unemployment,noise is information that hasn't arrived yet.It is simply uncertainty about future demand and supply conditions within and across sectors.When the information does arrive,the number of sectors where there is a good match between tastes and technology is an index of economic activity.In my model of the international economy,changing relative prices become noise that makes it difficult to see that demand and supply *Goldman,Sachs Co.I am grateful for comments on earlier drafts by Peter Bernstein,Robert Merton,James Poterba,Richard Roll,Hersh Shefrin,Meir Statman,Lawrence Summers,and Laurence Weiss. 529