Correlation Neglect in Financial Decision-Making

Erik Eyster and Georg Weizsäcker

No 1104, Discussion Papers of DIW Berlin from DIW Berlin, German Institute for Economic Research

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.

Keywords: Portfolio choice; correlation neglect; 1/n heuristic; biases in beliefs (search for similar items in EconPapers)
JEL-codes: B49 (search for similar items in EconPapers)
Pages: 41 p.
Date: 2011
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Citations: View citations in EconPapers (26)

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