A News-Utility Theory for Inattention and Delegation in Portfolio Choice
Michaela Pagel**
Columbia Graduate School of Business
Abstract
Recent evidence suggests that investors either are inattentive to their portfolios or undertake puzzling rebalancing efforts. This paper develops a life-cycle portfolio choice model in which the investor experiences loss-averse utility over news and can choose whether or not to look up his portfolio. I obtain three main predictions. First, the investor prefers to ignore and not rebalance his portfolio most of the time to avoid fluctuations in news utility. Such fluctuations cause a first-order decrease in expected utility because the investor dislikes bad news more than he likes good news. Consequently, the investor has a first-order willingness to pay a portfolio manager who rebalances actively on his behalf. Second, when the investor does look up his portfolio himself, he rebalances it extensively to hasten or delay the realization of good or bad news, respectively. Third, the investor would like to commit to being inattentive even more often because this would reduce overconsumption. Quantitatively, I structurally estimate the preference parameters by matching participation and stock shares over the life cycle. My parameter estimates are in line with the literature, generate reasonable intervals of inattention, and simultaneously explain consumption and wealth accumulation over the life cycle.
A News-Utility Theory for Inattention and Delegation in Portfolio Choice – Introduction
Standard finance theory says that investors should frequently rebalance their portfolios to realign their actual stock shares with their target shares, as stock prices frequently undergo large fluctuations. However, Bonaparte and Cooper (2009), Calvet et al. (2009a), Karlsson et al. (2009), Alvarez et al. (2012), and Brunnermeier and Nagel (2008) find that investors are inattentive and this inattention has been shown to matter in the aggregate by Chien et al. (fthc), Reis (2006), Gabaix and Laibson (2001), and Duffie and Sun (1990). Moreover, if investors are attentive, their rebalancing efforts do not seem to aim at well-defined target shares Hackethal et al. (2012) and Bergstresser et al. (2009) argue that investors overpay for delegated portfolio management, Calvet et al. (2009b) and Meng (2013) document that investors have a tendency to sell winning stocks (the disposition effect), and Feldman (2010) and Choi et al. (2009) argue that investors mentally separate their accounts as put forward in Thaler (1980).
This paper offers an explanation for both inattention and demand for delegated portfolio management that simultaneously speaks to both the disposition effect and the mentalaccounting phenomenon by assuming that the investor experiences utility over news that is, over changes in expectations about consumption. Such news-utility preferences were developed by Koszegi and Rabin (2006, 2007, 2009) to discipline the insights of prospect theory, and they have since been shown to explain a broad range of micro evidence. The preferences’ central idea is that bad news hurts more than good news pleases, which makes fluctuations in news utility painful in expectation and provides a micro foundation for inattention. This micro foundation has many implications for behavior and welfare. Most importantly, if a news-utility investor has access to both a brokerage and a checking account, he will choose to ignore his portfolio in the brokerage account and instead fund his consumption out of the checking account most of the time. The investor will also have a first-order willingness to pay for a portfolio manager to rebalance his portfolio actively for him, which reduces its risk. Occasionally, however, the investor must rebalance himself to smooth his consumption; in this case, he engages in behavior reminiscent of the disposition effect and realization utility in the spirit of Barberis and Xiong (2012). Moreover, the investor’s desire to separate accounts, his consumption, and his self-control problems are reminiscent of mental accounting. In addition to all this, I present the preferences’ implications for non-participation and stock shares in the presence of stochastic labor income to show that news utility also addresses pertinent questions in life-cycle portfolio theory.
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