706 JOURNAL OF POLITICAL ECONOMY earn a higher expected return than rational,sophisticated investors engaged in arbitrage against noise trading.This result obtains be- cause noise trader risk makes assets less attractive to risk-averse arbi- trageurs and so drives down prices.If noise traders on average over- estimate returns or underestimate risk,they invest more in the risky asset on average than sophisticated investors and may earn higher average returns.This result is more interesting than the point that if noise traders bear more fundamental risk they earn higher returns: our point is that noise traders can earn higher expected returns solely by bearing more of the risk that they themselves create.Noise traders can earn higher expected returns from their own destabilizing in- fluence,not because they perform the useful social function of bear- ing fundamental risk. Our model also has several implications for asset price behavior. Because noise trader risk limits the effectiveness of arbitrage,prices in our model are excessively volatile.If noise traders'opinions follow a stationary process,there is a mean-reverting component in stock returns.Our model also shows how assets subject to noise trader risk can be underpriced relative to fundamental values.We apply this idea to explain the underpricing of closed-end mutual funds,as well as the long-run underpricing of stocks known as the Mehra-Prescott(1985) puzzle.Finally,our model has several implications for the optimal investment strategy of sophisticated investors and for the possible role of long-term investors in stabilizing asset prices. We develop our two main arguments-that bearing noise trader risk raises noise traders'returns and that noise trader risk can explain several financial anomalies-in five sections.Section I presents a model of noise trader risk and shows how prices can diverge signifi- cantly from fundamental values.Section II calculates the relative ex- pected returns of noise traders and of sophisticated investors.Section III analyzes the persistence of noise traders in an extended model in which successful investors are imitated (as in Denton [1985]).Section IV presents qualitative implications of the model for the behavior of asset prices and market participants.Section V presents conclusions. I.Noise Trading as a Source of Risk The model contains noise traders and sophisticated investors.Noise traders falsely believe that they have special information about the future price of the risky asset.They may get their pseudosignals from technical analysts,stockbrokers,or economic consultants and irration- ally believe that these signals carry information.Or in formulating their investment strategies,they may exhibit the fallacy of excessive subjective certainty that has been repeatedly demonstrated in experi-