Correlation Neglect in Financial Decision-Making
43 Pages Posted: 7 Jan 2011 Last revised: 27 Feb 2011
Date Written: December 25, 2010
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
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