Limited Attention and Financial Decision Making

Abstract

Investor attention is a limited resource. This chapter discusses the literature on investor limited attention and its effects on capital markets. Theoretical and empirical studies find that, when some investors are inattentive, the immediate market reaction to news is incomplete, and stock prices exhibit post-announcement drift. Underreaction is stronger when investor attention is distracted by competing stimuli, when the information is less salient or harder to process, and when investors are less sophisticated. While retail investors suffer more, the effects of limited attention are also significant for sophisticated market participants, such as financial analysts, institutional investors, market makers, and financial data providers. Firms exploit investor limited attention by choosing disclosure timing and format to highlight good news and obscure bad news. Collectively, the studies reviewed here indicate that investor limited attention has important and far-reaching effects on capital markets.

Keywords: Limited attention, Market reaction to news and anomalies, PEAD, Investor sophistication, Financial intermediaries, Firm disclosure strategy

JEL Classification: G12, G14, G18, G28, G38, M41