Paper: "Noise Trader Risk in Financial Markets"

"Noise Trader Risk in Financial Markets" [pdf].

"In a world with mean-reverting noise traders' misperceptions, the optimal investment strategy is very different from the buy and hold strategy of the standard investment model. The optimal strategy for sophisticated investors is a market-timing strategy that calls for increased exposure to stocks after they have fallen and decreased exposure to stocks after they have risen in price. The strategy of betting against noise traders is a contrarian investment strategy: it requires investment in the market at times when noise traders are bearish, in anticipation that their sentiment will recover. The fundamentalist investment strategies of Graham and Dodd (1934) seem to be based on largely the same idea, although they are typically described in terms of individual stocks. The evidence on mean reversion in stock returns suggests that, over the long run, such contrarian strategies pay off."