Category Learning

Academic Research: Peng and Xiong 2006

Author: Daniel Seiler

Date: February 20, 2024

"Divide et impera," Latin for "divide and conquer" or "divide and rule," is a strategy commonly attributed to the Roman Republic in dealing with its enemies. Its underlying principle is straightforward yet potent for managing complex tasks in our daily lives. It suggests that by breaking down complex tasks into smaller, more manageable parts, they become easier to understand.

Complexity can be challenging because our brains lack the capacity to process every aspect of a problem at once. Unfortunately, our cognitive resources are not infinite, which is especially relevant to investing.

Lin Peng from Baruch College and Wei Xiong from Princeton have demonstrated that investor attention is a critical and limited resource that significantly affects asset prices and return dynamics. This is not new. The Romans knew it already.

What are interesting findings?

Market prices change not just because of new facts but also based on what investors pay attention to. This idea goes against the common belief that market prices quickly and correctly react to news. Daniel Kahneman, in his book "Attention and Effort" from 1973, points out that people, including those investing in stocks, can't focus on too much information at once. They have to pick what they think is most important. This means investors might pay more attention to big news and miss smaller, yet important, details. This oversight can cause stock prices to go up or down as the market slowly takes in new information.

Also, investors focusing on certain things might cause all the stocks in one area to move together in ways that don't just follow the basic facts about those companies. New technology might change this pattern.

Lastly, where investors choose to focus can make some stocks more predictable than others. Stocks in areas that get a lot of attention might be easier or harder to predict because of how much investors care about the small details of those companies.

Why is it important for us?

For thematic investors, the insights are essential:

Investors can't focus on everything at once, meaning market prices might not quickly reflect new information. For those focusing on specific themes, it suggests that price adjustments to theme-related news may lag.

Understanding where investors direct their limited attention is crucial in thematic investing. Recognizing how attention influences stock selection helps to identify potential mispricing.

These insights are key to uncovering undervalued investments and understanding how technology and investor biases affect market trends.