Portfolio Choice with Information-Processing Limits

Abstract

In this paper, we examine the joint consumption-portfolio decision of an agent with limited information-processing capacity (rational inattention or RI) in the sense of Sims (2003) within a non-linear-quadratic (non-LQ) setting. Our model predicts that, as processing capacity falls, agents choose to hold less of their savings in the form of risky assets on average; however, they still choose to hold substantial risky assets with some positive probability. Low capacity causes households to act as if they are more risk averse and more willing to substitute consumption intertemporally.