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The Perception of Dependence, Investment Decisions, and Stock Prices

Michael Ungeheuer and Martin Weber

No 11585, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: We study how investors perceive dependence between stock returns, how this influences investment decisions and stock prices. Our findings suggest that investors understand differences in dependence, but correlation does not properly capture their perception of dependence. In several laboratory experiments, we show that subjects understand dependence in frequent, moderate returns, but do not understand depedence in infrequent, extreme returns. Consistent with a counting heuristic, they diversify more at lower frequencies of comovement, even if correlation increases due to strong positive dependence in extreme returns. Applying our insights from experiments to 1963-2015 US stock returns, we find that there is a robust return premium for stocks with high frequencies of comovement with the market return. Our findings suggest that dependence between stock returns matters for investors and aggregate market outcomes. They also suggest that investors could improve portfolio selection by taking into account biased beliefs about dependence.

Keywords: Asset Pricing; Biased Beliefs; Correlation Neglect; Dependence; Diversification; Investment Decisions (search for similar items in EconPapers)
JEL-codes: C91 G02 G11 G12 (search for similar items in EconPapers)
Date: 2016-10
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