Costly Interpretation of Asset Prices

Xavier Vives; Liyan Yang;

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ABSTRACT

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, generating 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 sophistication levels by balancing the benefit of beating the market against the cost of acquiring sophistication. Investors tend to over-acquire sophistication. There can exist strategic complementarity in sophistication acquisition, leading to multiple equilibria.

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