The Free Energy Principle in Financial Markets: In Praise of “Noise Trading”

Individual investors frequently deviate from the principles of neoclassical finance by engaging in practices such as stock picking, trend following, and market timing. Such behavior is often deemed suboptimal. This article proposes an alternative perspective using Karl Friston’s Free Energy Principle. It suggests that these seemingly suboptimal actions are integral components of a broader process aimed at balancing action with perception. Active and frequent engagement with financial markets entails leveraging the informational and risk-balancing nature of such markets to receive feedback, facilitate learning, and adjust internal models to align with the external environment. The market-driven alignment between action and perception fosters a more adaptive interaction between individuals and their environment.