/ Dr. Steve Heinke
Limited information processing capacities and the investment decision
Due to the limitations in the information processing, an investor should concentrate on those types of information which promise the largest reduction in uncertainty for the portfolio.
In a world of readily available information, a human investor quickly reaches their information processing capacities. Given such constraints two questions naturally arise:
(1) How should the individual investor allocate these resources to lay foundations for the best decision?
(2) Are these constraints a potential source of often observed trading mistakes?
Any investor self-aware of these limitations in the information processing should concentrate on that type of information which promises the largest reduction in uncertainty for the portfolio. Thus, such an investor could for example reasonably neglect gathering information about Swiss federal bonds and focus on the developments of the stocks in the portfolio. In many cases it might even be beneficial to be inattentive to specific investment options or reduce the number of investments in the portfolio. In that case the available information processing capacities can be used to reduce the overall uncertainty remaining in the portfolio.
This last point might be an explanation for two regularly observed and costly trading mistakes. First, private investors tend to hold only few and not very diverse types of shares in their portfolio. This leads to clustered risk in the depot and reduces the expected return. Moreover, most private investors prefer to hold stocks of companies they know from their environment, like local or national companies, even though those companies may not be the most profitable ones. Nevertheless, it might be easier to receive higher quality news about such local companies compared to the closest competitor being miles away. The after work drink with a friend working at this company, or reading the local or national newspaper will provide en passent crucial information for the investor about this company.