Information Acquisition and Portfolio Under-Diversification

Abstract

We develop a rational model of investors who choose which asset payo®s to acquire informa-tion about, before forming portfolios. Scale economies in information acquisition lead investors to specialize in learning about a set of highly-correlated assets. Knowing more about these assets makes them less risky and more desirable to hold. Bene¯ts to specialization compete with bene¯ts to diversi¯cation. The resulting asset portfolios appear under-diversi¯ed from theperspective of standard theory, but are optimal. In equilibrium, information is a strategic substitute because assets that many investors learn about have low expected returns. Increasing returns, combined with strategic substitutability leads ex-ante identical investors to specialize in di®erent information, and hold different portfolios. Information choice rationalizes investingin a diversified fund and a set of highly-correlated assets, an allocation observed in the data but usually deemed anomalous.