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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.

Suggested Citation

  • Erik Eyster & Georg Weizsäcker, 2011. "Correlation Neglect in Financial Decision-Making," Discussion Papers of DIW Berlin 1104, DIW Berlin, German Institute for Economic Research.
  • Handle: RePEc:diw:diwwpp:dp1104
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    File URL: http://www.diw.de/documents/publikationen/73/diw_01.c.368611.de/dp1104.pdf
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    Cited by:

    1. Ungeheuer, Michael & Weber, Martin, 2016. "The Perception of Dependence and Investment Decisions," CEPR Discussion Papers 11188, C.E.P.R. Discussion Papers.
    2. Inés Moreno de Barreda & Gilat Levy & Ronny Razin, 2017. "Persuasion with Correlation Neglect: Media Power via Correlation of News Content," Economics Series Working Papers 836, University of Oxford, Department of Economics.
    3. Ungeheuer, Michael & Weber, Martin, 2016. "The Perception of Dependence, Investment Decisions, and Stock Prices," CEPR Discussion Papers 11585, C.E.P.R. Discussion Papers.
    4. David B. Johnson & Matthew D. Webb, 2017. "An Experimental Test of the No Safety Schools Theorem," Carleton Economic Papers 17-10, Carleton University, Department of Economics.
    5. Daniel Gottlieb & Kent Smetters, 2012. "Narrow Framing and Life Insurance," NBER Working Papers 18601, National Bureau of Economic Research, Inc.

    More about this item

    Keywords

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

    JEL classification:

    • B49 - Schools of Economic Thought and Methodology - - Economic Methodology - - - Other

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