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Entire industries vs specific stocks: What are the factors that impact investors’ judgment?


New MIT Sloan research shows how rational inattention theory plays a role in investment decision making

 CAMBRIDGE, Mass., March 13, 2024 – A peer-reviewed research paper from MIT Sloan School of Management assistant professor  takes a new look at rational inattention—a theory that argues we process information based on how we “rationally allocate” limited attention—to shed light on when and why investors focus on broad categories, such as blue chip stocks, versus drilling down into the details of individual companies.

 Among the study’s takeaways:

  • Money managers should recognize that their clients are more likely to be thinking about broad categories of stocks when distracted by world events.
  • Investors may miss relevant information about individual stocks when the market is volatile.
  • Fund managers should pay more attention to economic aggregates in recessions and to asset-specific shocks in booms. Accordingly, previous work has shown that successful managers time the market well in recessions and pick stocks well in booms.

Five experiments

Bhui and co-author Peiran Jiao, associate professor of finance at Maastricht University in the Netherlands, designed a simulated stock market game in which 883 subjects participated in five experiments in which they were asked to estimate the values of hypothetical stocks after acquiring a stream of information about factors that could potentially affect the stocks’ value. Subjects were provided with the opportunity to mouse over any combination of industry average and specific stocks, but within a limited time frame.

Bhui and Jiao analyzed how long subjects moused over different options, such as information about the industry as a whole or specific stocks. The researchers found that those participating in the study preferentially attended to information at the industry level when all of the stocks had similar values, when there were more stocks to evaluate, and when time constraints were more severe. This focus on the industry was linked to how well participants performed and was consistent with the theory of rational inattention.

Beware systematic errors

But while focusing on an entire industry such as tech or automotive, or a broad category such as blue chip stocks could be more efficient than delving into details of each individual company, Bhui notes that this can lead to systematic errors.

“Categorical thinking is a double-edged sword because it helps us to rapidly make sense of the world, but at the same time can lead us to mistakes,” says Bhui. One of the classic examples, says Bhui, is the dot-com bubble of the late 1990s, when companies boosted their stock value astronomically by simply adding “.com” to their names. “You're making a judgment of how good this company is based on its category.”

The best managers map out their strategy deliberately versus being reactionary, Bhui says. “If you are a firm that sells many products, it can be efficient to focus on shocks that affect demand for all products at the same time.”

Despite the wide-ranging impact of theories of rational inattention, “we still lack direct evidence for the crucial assumption that people rationally balance their attention between the category level and more-detailed level of an individual stock,” Bhui says. “Our work sharpens the link between categorical attention, behavior and performance, giving us a clearer view on the drivers and consequences of inattention.”

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