DP12360 Costly Interpretation of Asset Prices

Author(s): Jordi Mondria, Xavier Vives, Liyan Yang
Publication Date: October 2017
Date Revised: November 2020
Keyword(s): asset prices, Complementarity, Investor sophistication, price momentum
JEL(s):
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=12360

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. Our setup predicts price momentum and yields excessive 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. There can exist strategic complementarity in sophistication acquisition, leading to multiple equilibria.