Information Acquisition and Portfolio Underdiversification. Working paper

Individual investors hold a fraction of their equity portfolio in a highly-diversified mutual fund and another fraction in a small number of highly-correlated assets. Such behavior is optimal for investors who face constraints on how much they can learn. Optimal under-diversification arises because of increasing returns to scale in learning: As an investor holds more of an asset, the value of learning about it increases, but as he learns more about the asset, it becomes less risky, and more desirable to hold. The interaction of the information portfolio problem and the asset portfolio problem causes investors to hold some fraction of their assets in a well-diversified fund, about which they learn nothing, and to hold the other fraction in a small set of highly-correlated assets that they learn about