Disclosure and Rational Inattention

Abstract

Investors have a finite capacity to organize all information they receive from financial disclosures. In a model of rational inattention, we show that investor attention capacity affects the probability of disclosure. In the model, an informed firm makes a strategic voluntary disclosure subject to proprietary costs (Verrecchia 1983) or uncertainty about information endowment (Dye 1985), investors optimally allocate their attention as a function of their conjectures about the disclosure strategy. Our main result is that the probability of disclosure is inverse U-shaped in investor attention: for low levels of attention, more attention facilitates communication and increases disclosure; for high levels of attention, more attention better identifies, and therefore deters, unfavorable voluntary disclosure. We provide preliminary empirical evidence that the relationship between investor attention and management forecast is concave and inverse U-shaped, using institutional ownership as a proxy for investor attention.