Information Acquisition and Portfolio Under-Diversi¯cation

Abstract

We solve the problem of an investor who chooses which assets' payoff to acquire information about before making an investment decision. Investors specialize because information has increasing returns: As an investor learns more about an asset, it becomes less risky and more desirable to hold; as he holds more of the asset, the value of information about it increases. Investors hold some fraction of their assets in a well diversified fund, about which they learn nothing, and hold the other fraction in a small set of highly-correlated assets that they specialize in learning about. In equilibrium, ex-ante identical investors acquire different information. Information is a strategic substitute because assets that many investors learn about have low expected returns. The theory can explain the empirical evidence that individual investors hold part of their equity portfolio in diversified mutual funds and the rest in a small number of highly-correlated assets. While such portfolios may appear under-diversified, they are optimal for investors who face constraints on how much information they can acquire.