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Rational Inattention and Portfolio Selection

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  • LIXIN HUANG
  • HONG LIU

Abstract

Costly information acquisition makes it rational for investors to obtain important economic news with only limited frequency or limited accuracy. We show that this rational inattention to important news may make investors over- or underinvest. In addition, the optimal trading strategy is "myopic" with respect to future news frequency and accuracy. We find that the optimal news frequency is nonmonotonic in news accuracy and investment horizon. Furthermore, when both news frequency and news accuracy are endogenized, an investor with a higher risk aversion or a longer investment horizon chooses less frequent but more accurate periodic news updates. Copyright 2007 by The American Finance Association.

Suggested Citation

  • Lixin Huang & Hong Liu, 2007. "Rational Inattention and Portfolio Selection," Journal of Finance, American Finance Association, vol. 62(4), pages 1999-2040, August.
  • Handle: RePEc:bla:jfinan:v:62:y:2007:i:4:p:1999-2040
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    Citations

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    Cited by:

    1. Goddard, John & Kita, Arben & Wang, Qingwei, 2015. "Investor attention and FX market volatility," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 38(C), pages 79-96.
    2. Alldredge, Dallin M. & Cicero, David C., 2015. "Attentive insider trading," Journal of Financial Economics, Elsevier, vol. 115(1), pages 84-101.
    3. Pasten, Ernesto & Schoenle, Raphael, 2016. "Rational inattention, multi-product firms and the neutrality of money," Journal of Monetary Economics, Elsevier, vol. 80(C), pages 1-16.
    4. Zhu, Yingzi & Zhou, Guofu, 2009. "Technical analysis: An asset allocation perspective on the use of moving averages," Journal of Financial Economics, Elsevier, vol. 92(3), pages 519-544, June.
    5. Michele Longo & Alessandra Mainini, 2017. "Welfare effects of information and rationality in portfolio decisions under parameter uncertainty," Papers 1709.04387, arXiv.org.
    6. Yulei Luo & Eric R. Young, 2016. "Long‐Run Consumption Risk and Asset Allocation under Recursive Utility and Rational Inattention," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 48(2-3), pages 325-362, March.
    7. Ling, Aifan & Sun, Jie & Yang, Xiaoguang, 2014. "Robust tracking error portfolio selection with worst-case downside risk measures," Journal of Economic Dynamics and Control, Elsevier, vol. 39(C), pages 178-207.
    8. Wang, Honglin & Yu, Fan & Reardon, Thomas & Huang, Jikun & Rozelle, Scott, 2013. "Social learning and parameter uncertainty in irreversible investments: Evidence from greenhouse adoption in northern China," China Economic Review, Elsevier, vol. 27(C), pages 104-120.
    9. Yulei Luo, 2006. "Rational Inattention, Portfolio Choice, and the Equity Premium," Computing in Economics and Finance 2006 56, Society for Computational Economics.
    10. Michaely, Roni & Rubin, Amir & Vedrashko, Alexander, 2016. "Are Friday announcements special? Overcoming selection bias," Journal of Financial Economics, Elsevier, vol. 122(1), pages 65-85.
    11. Jordi Mondria & Climent Quintana‐Domeque, 2013. "Financial Contagion and Attention Allocation," Economic Journal, Royal Economic Society, vol. 123(568), pages 429-454, May.
    12. Boyarchenko, Nina, 2012. "Information acquisition and financial intermediation," Staff Reports 571, Federal Reserve Bank of New York, revised 01 Jun 2014.
    13. Suleyman Basak & Georgy Chabakauri, 2010. "Dynamic Mean-Variance Asset Allocation," Review of Financial Studies, Society for Financial Studies, vol. 23(8), pages 2970-3016, August.
    14. Kang, Johnny & Pekkala, Tapio & Polk, Christopher & Ribeiro, Ruy, 2011. "Stock prices under pressure: how tax and interest rates drive returns at the turn of the tax year," LSE Research Online Documents on Economics 43096, London School of Economics and Political Science, LSE Library.
    15. Batchuluun, Altantsetseg & Luo, Yulei & Young, Eric, 2014. "Portfolio Choice with Information-Processing Limits," MPRA Paper 58538, University Library of Munich, Germany.
    16. Manela, Asaf & Moreira, Alan, 2017. "News implied volatility and disaster concerns," Journal of Financial Economics, Elsevier, vol. 123(1), pages 137-162.
    17. Luo, Yulei & Young, Eric, 2013. "Rational Inattention in Macroeconomics: A Survey," MPRA Paper 54267, University Library of Munich, Germany.

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