A Contribution to the Theory of Information Acquisition in Financial Markets

In order to explore the incentives for information acquisition in financial markets, a model of the joint information and portfolio choice is developed. Investors are allowed to acquire a number of signals that inform about a risky asset’s dividend, and “informational efficiency” is defined as a social planner’s preferred signal allocation. If prices are fully revealing, a complete rational expectations equilibrium exists—contrary to a wide-held conjecture. The equilibrium entails no information acquisition and is informationally efficient. The reason is that the transmission of information through price to other investors brings market expectations closer to each investor’s own expectations. This reduces the difference between expected payoffs and the asset price, a negative effect of more information. When prices are only partly informative, some investors start acquiring information as long as markets are sufficiently small so that prices reveal little information to others. However, the acquisition of more information inflicts a negative externality on uninformed investors who rationally extract information from price. Thus, markets are likely to be informationally inefficient as informed investors tend to acquire too much information. JEL: G14, D81 ∗[email protected] (URL: http://socrates.berkeley.edu/ ̃muendler/). I have benefited from very insightful discussions with Maury Obstfeld and early explorations with Andy Rose. I am greatful to Achim Wambach, Sven Rady, and seminar participants at Ibmec Rio de Janeiro and the University of Munich for many helpful comments. Needless to say, remaining mistakes are not welcome but mine.