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The role of attention constraints for investor behavior and economic aggregates: what have we learnt so far?

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Abstract

Motivated by insights from psychology, a growing body of behavioral finance research highlights the importance of investors’ attention constraints. Collectively, this work suggests that time-series and cross-sectional variation in attention might not only materially affect the quality of market participants’ individual decision making, but eventually also matter for economic aggregates such as stock-level returns. While being notoriously difficult to measure, taking the role of human attention constraints into account might enable researchers to arrive at a better understanding of actual investor behavior as well as puzzling market phenomena, both of which are hard to reconcile with standard finance theory. Against this background, the goal of this paper is twofold. First, and with a focus on empirical work, it aims at providing a (necessarily selective) review, assessment, and synthesis of the research on limited investor attention. Second, it tries to identify gaps in the literature and to suggest fruitful directions for future research.

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Notes

  1. However, it should be noted that the importance of attention allocation in financial markets has also sporadically been highlighted in some early and by now much cited work. Two examples from later Nobel laureates are the following. The investor recognition model of Merton (1987) posits that constrained investors are aware only of a subset of securities in the stock universe. In equilibrium, this makes the so-called shadow cost of information, which might be considered as being a proxy for the information incompleteness about a stock, a determinant of expected returns. Moreover, early studies by Shiller highlight the link between time-varying investor attention and stock market returns (e.g. Shiller 1984, 1989, 1999).

  2. The selection process is based on several factors. On the one hand, it includes quantifiable variables such as journal quality, citations counts, and time of publication. On the other hand, it also includes a subjective assessment of a paper’s quality and contribution to the field of investor attention. Even though the review attempts to identify and cover the most relevant work, it is doubtlessly possible that some key papers have still been omitted.

  3. The PEAD refers to the empirically observable phenomenon that firms with positive (negative) earnings surprises tend to yield positive (negative) abnormal returns for up to three months after the public announcement. In other words, there appears to be a predictable stock price drift in the same direction as the earnings surprise. In line with their hypothesis, all studies mentioned above find that the PEAD is stronger if earnings are announced on days during which investors are assumed to be less attentive.

  4. Work in other areas of economics strengthens the conjecture that limited attention might adversely effect individuals’ welfare. For instance, see Hossain and Morgan (2006) for inattention towards shipping costs in eBay auctions, Chetty et al. (2009) for inattention to intransparent taxes, or Stango and Zinman (2014) for inattention to checking account overdraft fees. See DellaVigna (2009) for a recent overview.

  5. See e.g. Barber and Odean (2013) for a recent review. Among the best documented investment mistakes are the following: Retail investors show a disposition to sell winning stocks too early and hold on to losing stocks too long (e.g. Odean 1998; Shefrin and Statman 1985; Weber and Camerer 1998). They often trade excessively (e.g. Barber and Odean 2000; Odean 1999). They tend to forgo the benefits of diversification (e.g. Benartzi 2001; French and Poterba 1991; Goetzmann and Kumar 2008; Grinblatt and Keloharju 2001; Kilka and Weber 2000).

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    Heiko Jacobs

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H. Jacobs: Parts of this review are based on the introduction of my Ph.D. thesis “Empirical Essays on the Stock Market Impact of Limited Investor Attention” (2011, University of Mannheim).

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Jacobs, H. The role of attention constraints for investor behavior and economic aggregates: what have we learnt so far?. Manag Rev Q 65, 217–237 (2015). https://doi.org/10.1007/s11301-015-0112-5

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