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Correlation Neglect in Financial Decision-Making

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  • Erik Eyster
  • Georg Weizsäcker

Abstract

Good 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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File URL: http://www.diw.de/documents/publikationen/73/diw_01.c.368611.de/dp1104.pdf
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Bibliographic Info

Paper provided by DIW Berlin, German Institute for Economic Research in its series Discussion Papers of DIW Berlin with number 1104.

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Length: 41 p.
Date of creation: 2011
Date of revision:
Handle: RePEc:diw:diwwpp:dp1104

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Keywords: Portfolio choice; correlation neglect; 1/n heuristic; biases in beliefs;

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Cited by:
  1. Daniel Gottlieb & Kent Smetters, 2012. "Narrow Framing and Life Insurance," NBER Working Papers 18601, National Bureau of Economic Research, Inc.

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