Correlation Neglect in Financial Decision-Making
AbstractGood decision-making often requires people to perceive and handle a myriad of statistical correlations. Notably, optimal portfolio theory depends upon a sophisticated understanding of the correlation among financial assets. In this paper, we examine people's understanding of correlation using a sequence of portfolio-allocation problems and find it to be strongly imperfect. Our experiment uses pairs of portfolio-choice problems that have the same asset span - identical sets of attainable returns - and differ only in the assets' correlation. While any outcome-based theory of choice makes the same prediction across paired problems, subjects behave very differently across pairs. We find evidence for correlation neglect - treating correlated variables as uncorrelated - as well as for a form of "1/N heuristic" – investing half of wealth each of the two available assets.
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Bibliographic InfoPaper provided by DIW Berlin, German Institute for Economic Research in its series Discussion Papers of DIW Berlin with number 1104.
Length: 41 p.
Date of creation: 2011
Date of revision:
Portfolio choice; correlation neglect; 1/n heuristic; biases in beliefs;
Find related papers by JEL classification:
- B49 - Schools of Economic Thought and Methodology - - Economic Methodology - - - Other
This paper has been announced in the following NEP Reports:
- NEP-ALL-2011-02-26 (All new papers)
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