Correlation Neglect in Financial Decision-Making

43 Pages Posted: 7 Jan 2011 Last revised: 27 Feb 2011

See all articles by Erik Eyster

Erik Eyster

London School of Economics & Political Science (LSE) - Department of Economics

Georg Weizsacker

Humboldt University Berlin; DIW Berlin

Date Written: December 25, 2010

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 in each of the two available assets.

Keywords: portfolio choice, correlation neglect, 1/n heuristic, biases in beliefs

JEL Classification: B49

Suggested Citation

Eyster, Erik and Weizsacker, Georg, Correlation Neglect in Financial Decision-Making (December 25, 2010). DIW Berlin Discussion Paper No. 1104. Available at SSRN: https://ssrn.com/abstract=1735339 or http://dx.doi.org/10.2139/ssrn.1735339

Erik Eyster

London School of Economics & Political Science (LSE) - Department of Economics ( email )

Houghton Street
London WC2A 2AE
United Kingdom

Georg Weizsacker (Contact Author)

Humboldt University Berlin ( email )

Spandauer Str. 1
Berlin, D-10099
Germany

DIW Berlin

Mohrenstr. 58
Berlin
Germany

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