Circle of Competence and the Gradual Diffusion of Information in Prices
50 Pages Posted: 19 Nov 2013 Last revised: 3 Feb 2016
Date Written: January 31, 2016
I examine how information in the price of one firm is incorporated into the price of another related firm. Information in prices diffuses slowly across firms affected by common shocks. Further, this phenomenon is most pronounced across firms each affected by many types of shocks, i.e. complex firms. To explain these empirical regularities, I incorporate structural uncertainty and ambiguity aversion into a standard multi-asset rational expectation model. In the model, each firm is affected by multiple types of shocks and investors, endowed with limited kinds of expertise, do not know the riskiness, i.e. volatility, of some of these shocks. Investors are especially fearful of unknown risks, so they assume that shocks of unknown riskiness are extremely risky in their investment decisions. This behavior prevents the price of one firm from efficiently incorporating information in the price of a related firm, especially if both firms in the pair are complex firms. The model also explains the diversification discount.
Keywords: Asset Pricing under Incomplete Information, Ambiguity Aversion, Return Predictability, Complex Firms
JEL Classification: G10, G11, G14
Suggested Citation: Suggested Citation