Costly Interpretation of Asset Prices

We propose a model in which investors cannot costlessly process information from asset prices. At the trading stage, investors are boundedly rational and their interpretation of prices injects noise into the price system, which serves as a source of endogenous noise trading. Compared to the standard rational expectations equilibrium, our setup features price momentum and yields higher return volatility and excessive trading volume. In an overall equilibrium, investors optimally choose their sophistication levels by balancing the benefit of beating the market against the cost of acquiring sophistication. Sophistication acquisition helps to improve social welfare by curbing the welfare loss from speculative trading. There can exist strategic complementarity in sophistication acquisition, leading to multiple equilibria.