Tuesday, March 7, 2023

Rational inattention - An important concept for investors


In an information-rich world, the wealth of information means a dearth of something else: a scarcity of whatever it is that information consumes. What information consumes is rather obvious: it consumes the attention of its recipients. Hence a wealth of information creates a poverty of attention and a need to allocate that attention efficiently among the overabundance of information sources that might consume it.

- Herbert Simon 

Attention matters. Where we focus our attention will make all the difference with whether we are successful investors. Miss the details and you miss the returns. Miss the right data and you will fail. Use the right information and you will be a success. Show the right attention and you are a winner. This is why we go back to the core statements from Herbert Simon.

All the information is out there, you just need to know where to look and what to process. Unfortunately, the more information the less likely you will use all of it. Economist have turned this discussion into analysis of rational inattention; the acquisition or use of information is costly because we are cognitively limited, so you must choose wisely what information to look at. See "Rational Inattention: A Review"

The effective quant strategy is one that knows where to place the right information attention to better process information versus the market. Winning at the inattention problem is focusing in on the right information and reducing noise at the right time. 

There are several ways to fight the rational inattention problem. One is to try and use all information and be a super-processor of information. This may be a fool's game, yet the best fundamental analysts try and to play it and are at times successful at this game. However, one slip of attention and the downside risk will be great. The other extreme would be hold an index fund. You don't have to worry about inattention because you are not processing any information. 

There are other alternatives. One view would be to focus on price signals. Price aggregate information so this is a natural to focus our attention. If a price is trending up, it should capture our attention. If a price jumps, it should capture our attention. The trend-follower solve the rational inattention problem through focus on searching through prices. Another alternative is to combine trends with fundamental information in a quant model. Let a computer focus attention through looking at the link between trends and other information. A computer programs can have infinite attention but only at those things that it is programmed to focus on.

Behavioral biases exist because of our cognitive limitations, so a crucial issue is trying to train ourselves to avoid inattention issues.

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