Information Acquisition and Portfolio Under-Diversification

We develop a rational model of investors who choose which asset payoffs to acquire information 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. Benefits to specialization compete with benefits to diversification. The resulting asset portfolios appear under-diversified from the perspective 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 different information, and hold different portfolios. Information choice rationalizes investing in a diversified fund and a set of highly-correlated assets, an allocation observed in the data but usually deemed anomalous. ∗Van Nieuwerburgh: New York University, Stern School of Business, 44 West Fourth St., 9-190, New York, NY 10012 (email:[email protected]). Veldkamp: New York University, Stern School of Business, 44 West Fourth St., 7-180, New York, NY 10012 (email:[email protected]). We thank Dave Backus, Bernard Dumas, Ned Elton, Diego Garcia, Fatih Guvenen, Bob Hall, Ron Kaniel, Hanno Lustig, Massimo Massa, Pascal Maenhout, Antii Petajisto, Urs Peyer, Matthew Pritsker, Tom Sargent, Chris Sims, Eric Van Wincoop, Pierre-Olivier Weill, seminar participants at NYU, Cornell, USC, UCLA, Stanford, UCSB, INSEAD, Ohio State, and the Federal Board of Governors, and participants at the 2005 SED meetings, the 2005 Gerzensee Summer AP Institute, the 2005 Econometric Society World Congress, and the 2005 EFA and FMA meetings for helpful comments. JEL classification: D83, D82, G11.