Do Noisy Stock Prices Impede Real Efficiency?

Abstract

Using volatile and correlated liquidity shocks to investors as a source of noise trading, I show that noise in stock prices impedes real efficiency. A one-standard-deviation increase in mutual fund flow-driven volatility pressure leads to a 2.6%–4.0% decline in return on assets and a $22.6 million loss in cash flow in the subsequent two years. Noise in stock prices does not affect product market demand, but it reduces firms’ total factor productivity, profit margin, and performance in research and development and acquisitions. Further evidence suggests that noise in stock prices impedes real efficiency through three plausible channels: distorting firms’ investment decisions through misleading price signals, increasing the cost of capital, and reducing the efficacy of equity-based incentive contracts. This paper was accepted by Gustavo Manso, finance.

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