Information acquisition and portfolio performance

1. Information acquisition and portfolio performance Luigi Guiso (European University Institute , Ente Einaudi & CEPR) Tullio Jappelli (University of Salerno, CSEF & CEPR)

2. Fact 1: Heterogeneity in investment in financial information 0 Equivalent working days in a year 1.5 4.5 8.4 18 33 42 “How much time do you spend, on average each week, to collect information on how to invest your wealth and manage your investments?” (think about time reading newspapers, surfing the intern etc., talking to your financial advisor, analyzing balance sheets etc.).

3. Fact 2: Heterogeneity in portfolio performance Mean: 0.26

4. Relation between information and portfolio performance • Why does portfolio performance vary across investors? • Why does investment in information differ? • Is heterogeneity in performance related to heterogeneity in information? • We contrast the implications of rational and overconfidence models of portfolio choice.

5. Models with rational agents • At a cost, investors can obtain a private signal about risky assets returns. • Those who are likely to benefit more from information, purchase more information. • Since information is valuable, those who purchase more information achieve also a higher Sharpe ratio. • Implication 1: Investment in financial information increases with wealth, risk tolerance, and any variable that boosts stock investment. It falls with the marginal costs of collecting information (Verrecchia (1982), Peress (2004)). • Implication 2: The portfolio Sharpe ratio is an increasing function of investment in information (Peress (2004))

6. Models with overconfident investors • Investors optimize, but overstate the quality of private information: they are overconfident about the quality of their signal => Investors accumulate too much information and overreact to it. • Implication 1: Investment in financial information depends on the same variables as in rational model + increases with (un-observable) overconfidence. It is observationally equivalent in the R&B models. • Implication 2: The Sharpe ratio (may) fall with investment in information; the more so the higher the degree of overconfidence.

7. Rational and overconfidence models: summary of implications

8. The Data • We use a survey of customers of an Italian leading bank (more than 4 million accounts) conducted in the Fall of 2003. • Sample of 1,834 customers, is representative of eligible population of customers Collects data on • Investment in financial information • Portfolio composition • Willingness to bear financial risk • Socioeconomic variables (age, education, income, etc) • Assets knowledge Additional data on • Frequency of trading • Delegation of financial decisions

9. Measuring investment in information • Time spent in financial information: ranges from “no time” to “over 7 hours per week”. • How much time do you usually spend, in a week, to acquire information on how to invest your savings? (think about time reading newspapers, surfing the intern et, talking to your financial advisor, etc.).

10. Time spent collecting financial information

11. What determines investment in information? • Not useful to discriminate between R&B models => both models imply the same variables should matter and have similar effects. But… • Interesting in itself • Helps reassure us about the quality of the data • Suggests potential instruments for IV regressions of effect of information on portfolio performance • Might be suggestive of overconfidence=> if overconfidence plays a role, proxies for overconfidence should matter

12. Explanatory variables • household’s financial wealth • Financial and real assets of both the CC holder and the household • Risk tolerance • “In managing your financial investment, you think you are a person that is interested in investments that offer the possibility of: • a high return, with a high risk of capital losses (3.4%) • good return and reasonable risk (32.4%) • moderate return, and good degree of safety (44.6%) • low return, without any risk of losing the capital (19.6%). • Risk should be regarded as an opportunity (29%) or as a danger against which to be safeguarded (71%) • Marginal costs of collecting information • Education • Dummy for being retired • Others: background risk and demographics

13. Investment in information and financial wealth(minutes per week)

14. Investment in information and education(proxy for the marginal cost of gathering information)

15. Results: investment in information

16. Measuring portfolio performance • We classify assets in 5 groups • Risk-free (short-term bonds) • Medium-term bonds • Long-term bonds • Stocks • (mutual funds and managed investment accounts are allocated to one or more groups) • 1989-2003 semiannual returns are used to compute, for each investor, expected portfolio return, standard deviation and Sharpe ratio. • The Sharpe ratio is not adjusted for information or trading costs.

17. Information and the Sharpe ratio

18. Relation between performance and information • Selectivity adjustment • Endogeneity: Information might be correlated with unobservable variables: • Ability to manage the portfolio. The more able may need to collect less information. • Taste for finance. Some enjoy investing in stocks, and this utility gain is not reflected in returns. Those who enjoy investing in stocks, also enjoy collecting information. • IV approach. • Instruments: background risk, dummy for retirement.

19. The effect of information on the Sharpe ratio

20. Proxying for overconfidence Claim knowledge of stocks.How well do you think you know stocks?” not at all / little / medium / well / very well. (Klayman et. 1999; Weinstein (1980), Svenson (1981)) Gender. Overconfidence is task-specific. In “masculine” tasks men are more overconfident than women. (Lundeberg, Fax and Puncochar, 1994; Barber and Odean (2001)

21. Sample splits by degree of overconfidence

22. Extensions: contrast the two models from three different angles • Frequency of trading. Those who collect more info=> trade more frequently, effect stronger for the more overconfident; more trading => lower Sharpe ratio. • Delegation of financial decisions. Those who collect more info=> delegate less, effect stronger for the more overconfident; lower delegation => lower Sharpe ratio. • Diversifications of stock portfolio. Those who collect more info=> diversify less, effect stronger for the more overconfident; those who diversify less => lower Sharpe ratio.

23. Ex. 1: Investment in information and trading • Both R&B models => Trading increases with information • O-model implies: Larger effect for more overconfident Trading is negatively correlated with the Sharpe ratio • R-model implies: Trading positively correlated with the Sharpe ratio Use data on how often investors make financial transactions: ranging from 0 - never trades - to 360: buys or sells every day. < than once a year once a year Never 3 months 1 months 6 months Maturity daily 1 w 2 w

24. Ex: 1 Information and frequency of trading A. Whole sample B. Sample splits by overconfidence

25. Ex: 1 Sharpe ratio and frequency of trading

26. Extension 2: Information and delegation • Information collection affects the willingness to consult financial advisors and delegate decisions to them. • The more information one collects on his own, the less he needs to delegate and consult the advisor. • The more overconfident will delegate less (than optimal) => those who delegate less attain a lower Sharpe ratio • Test two implications of O model: • Delegation falls with information collection, the more so the more one is overconfident. • The Sharpe ratio is positively correlated with delegation. • Data on delegation: 1 do it alone (28%); consult but do alone (58%); delegate but monitor (11%); full delegation (4%).

27. The effect of information on delegation

28. The effect of delegation on the Sharpe ratio

29. Ext. 3: Information and diversification (stock picking) • Overconfident investors overvalue their signals and should thus engage more in stock picking • Since signals are mis-calibrated, those who engage more in stock picking end up with less diversified portfolios and lower Sharpe ratios: • More information is associated with less diversification (more stock picking) • less diversification is associates with a lower Sharpe ratio • We measure stock picking with an index of diversification: indirectly held stocks/(directly +indirectly held stock)

30. Effect of information on diversification

31. Effect of diversification on Sharpe ratio

32. Do biases disappear with wealth? • Important for two reasons: • Asset pricing: The wealthy are critical as they hold most of the assets=> mis-pricing due to overconfidence depends critically on how mis-calibrated are the wealthy • Wealth distribution: mis-processing of information may be a source of enhancement of wealth inequality if the less wealthy are more subject to it

33. 0 Sharpe Ratio 0 2 4 6 8 Investment in information Information, the Sharpe ratio and wealth w>90th 10<w<90th w<10th

34. Summary of results • Investors accumulate information in ways consistent with utility maximization • Those who collect more information obtain higher returns, but take too much risk, and end up with less efficient portfolios • Evidence consistent with models where investors misinterpret information due to cognitive limitations • The wealthy seem less prone to misinterpreting information than the poor