Active and Passive Information Acquisition: Application to Financial Markets

Abstract

Investors overreact to salient information and neglect nonsalient information. I conjecture that this is the result of cognitively effortful information processing with limited processing capacity and heterogeneous processing costs. On the one hand, the allocation of the limited information-processing capacities is subject to the means and objectives of the decision maker, that is, (active) goal-driven attention. On the other, the salience or visibility of news affecting the processing cost, that is, external (passive) stimulus-driven attention. I model this by extending the framework of rational inattention by heterogeneous marginal costs of the information processing, which are dependent on the visibility of the piece of information. This model of information processing is applied to a simple asset-pricing model. The main findings are that higher visibility of a piece of information leads to a lower risk premium, more informativeness, and a stronger reaction of the asset price to the piece of information. Furthermore, there exists a visibility threshold beyond which the investor decreases the attention capacities spent on a piece of information. Finally, investors will neglect a piece of information if it is below a threshold of visibility. Explicitly modeling the relevant aspects of information acquisition of a decision maker helps make sense of contradictory empirical results and can be useful for more structural estimations in the future.