Are Information and Portfolio Diversification Substitutes or Complements?

Abstract

Whenever a new financial product is offered by the financial industry, a rational investor faces a trade off between diversification benefits and costs of "getting to know" the newly introduced asset. In this paper the investor who can diversify can also decide either to pay a fee and separate the information on different risks affecting his asset value, or to remain uninformed and receive a non-separating signal. The uninformed investor optimally filters his pooled signal. The paper provides conditions under which diversification benefits are exploited, with or without information acquisition. We discuss lack of diversification and under-diversification and provide conditions under which each of them applies.

Keywords: Information costs, Optimal filtering, Portfolio diversification

JEL Classification: G11, G14