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Rational Inattention and Portfolio Selection

Authors

  • LIXIN HUANG,

  • HONG LIU

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    • Huang is from Georgia State University and City University of Hong Kong and Liu is from Washington University in Saint Louis. We are very grateful to an anonymous referee, Kerry Back, Suleyman Basak, Alex David, Jérôme Detemple, Gary Gorton, Qiang Kang, Richard Kihlstrom, Yuming Li, Jianjun Miao, Rob Stambaugh (the Editor), Yihong Xia, Guofu Zhou, and seminar participants at the 2004 American Finance Association conference, the 2003 Midwest Finance Association conference, Boston University, the Hong Kong University of Science and Technology, the University of Missouri at Columbia, the University of North Carolina at Chapel Hill, and Washington University in Saint Louis for helpful comments. Huang acknowledges research funding provided by a grant from City University of Hong Kong (project no. 7001870).


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.

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