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Correlation Neglect in Belief Formation

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  • Enke, Benjamin

    () (University of Bonn)

  • Zimmermann, Florian

    () (briq, University of Bonn)

Abstract

Many information structures generate correlated rather than mutually independent signals, the news media being a prime example. This paper shows experimentally that in such contexts many people neglect these correlations in the updating process and treat correlated information as independent. In consequence, people's beliefs are excessively sensitive to well-connected information sources, implying a pattern of "overshooting" beliefs. Additionally, in an experimental asset market, correlation neglect not only drives overoptimism and overpessimism at the individual level, but also affects aggregate outcomes in a systematic manner. In particular, the excessive confidence swings caused by correlated signals give rise to predictable price bubbles and crashes. These findings are reminiscent of popular narratives according to which aggregate booms and busts might be driven by the spread of "stories". Our results also lend direct support to recent models of boundedly rational social learning.

Suggested Citation

  • Enke, Benjamin & Zimmermann, Florian, 2013. "Correlation Neglect in Belief Formation," IZA Discussion Papers 7372, Institute for the Study of Labor (IZA).
  • Handle: RePEc:iza:izadps:dp7372
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    References listed on IDEAS

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    Cited by:

    1. Krishna Dasaratha & Kevin He, 2017. "Network Structure and Naive Sequential Learning," Papers 1703.02105, arXiv.org, revised Jun 2018.
    2. Alejandro Martínez-Marquina & Muriel Niederle & Emanuel Vespa, 2017. "Probabilistic States versus Multiple Certainties: The Obstacle of Uncertainty in Contingent Reasoning," NBER Working Papers 24030, National Bureau of Economic Research, Inc.
    3. Bormann, Sven-Kristjan, 2013. "Sentiment indices on financial markets: What do they measure?," Economics Discussion Papers 2013-58, Kiel Institute for the World Economy (IfW).
    4. Anna Bayona & Jordi Brandts & Xavier Vives, 2016. "Supply Function Competition, Private Information, and Market Power: A Laboratory Study," Working Papers 916, Barcelona Graduate School of Economics.
    5. Levy, Gilat & Razin, Ronny, 2017. "The coevolution of segregation, polarized beliefs and discrimination: the case of private versus state education," LSE Research Online Documents on Economics 68532, London School of Economics and Political Science, LSE Library.
    6. repec:eee:gamebe:v:109:y:2018:i:c:p:262-270 is not listed on IDEAS
    7. Dmitry Taubinsky & Alex Rees-Jones, 2016. "Attention Variation and Welfare: Theory and Evidence from a Tax Salience Experiment," Natural Field Experiments 00563, The Field Experiments Website.
    8. Nuzzo, Simone & Morone, Andrea, 2017. "Asset markets in the lab: A literature review," Journal of Behavioral and Experimental Finance, Elsevier, vol. 13(C), pages 42-50.
    9. Pietro Ortoleva & Erik Snowberg, 2015. "Overconfidence in Political Behavior," American Economic Review, American Economic Association, vol. 105(2), pages 504-535, February.
    10. repec:aea:jecper:v:32:y:2018:i:1:p:155-78 is not listed on IDEAS
    11. 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.
    12. Alice Hsiaw & Ing-Haw Cheng, 2016. "Distrust in Experts and the Origins of Disagreement," Working Papers 110, Brandeis University, Department of Economics and International Businesss School.
    13. Eyster, Erik & Rabin, Matthew & Weizsäcker, Georg, 2015. "An Experiment on Social Mislearning," CEPR Discussion Papers 11020, C.E.P.R. Discussion Papers.
    14. Andrew Ellis & Michele Piccione, 2017. "Correlation Misperception in Choice," American Economic Review, American Economic Association, vol. 107(4), pages 1264-1292, April.
    15. Xavier Gabaix, 2017. "Behavioral Inattention," NBER Working Papers 24096, National Bureau of Economic Research, Inc.
    16. Christine L. Exley & Judd B. Kessler, 2017. "Motivated Errors," Harvard Business School Working Papers 18-017, Harvard Business School, revised May 2018.
    17. Brandts, Jordi & Giritligil, Ayça Ebru & Weber, Roberto A., 2015. "An experimental study of persuasion bias and social influence in networks," European Economic Review, Elsevier, vol. 80(C), pages 214-229.
    18. Epstein, Larry G. & Halevy, Yoram, 2017. "Ambiguous Correlation," Microeconomics.ca working papers yoram_halevy-2017-2, Vancouver School of Economics, revised 09 Jan 2018.
    19. Barron, Kai, 2016. "Belief updating: Does the 'good-news, bad-news' asymmetry extend to purely financial domains?," Discussion Papers, Research Unit: Economics of Change SP II 2016-309, Social Science Research Center Berlin (WZB).
    20. Schüssler, Katharina, 2018. "The Influence of Overconfidence and Competition Neglect On Entry Into Competition," Rationality and Competition Discussion Paper Series 87, CRC TRR 190 Rationality and Competition.
    21. Alice Hsiaw & Ing-Haw Cheng, 2016. "Distrust in Experts and the Origins of Disagreement," Working Papers 110R3, Brandeis University, Department of Economics and International Businesss School, revised Mar 2018.
    22. Martin Geiger & Richard Hule, 2017. "The role of correlation in two-asset games: Some experimental evidence," Working Papers 2017-19, Faculty of Economics and Statistics, University of Innsbruck.
    23. Bohren, Aislinn & Hauser, Daniel, 2017. "Bounded Rationality And Learning: A Framework and A Robustness Result," CEPR Discussion Papers 12036, C.E.P.R. Discussion Papers.

    More about this item

    Keywords

    beliefs; correlation neglect; experiments; markets; overshooting;

    JEL classification:

    • C91 - Mathematical and Quantitative Methods - - Design of Experiments - - - Laboratory, Individual Behavior
    • D03 - Microeconomics - - General - - - Behavioral Microeconomics: Underlying Principles
    • D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search; Learning; Information and Knowledge; Communication; Belief; Unawareness
    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
    • D40 - Microeconomics - - Market Structure, Pricing, and Design - - - General

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