Correlation Neglect in Belief Formation

37 Pages Posted: 11 May 2013

Multiple version iconThere are 2 versions of this paper

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.

Keywords: beliefs, correlation neglect, experiments, markets, overshooting

JEL Classification: C91, D03, D83, D84, D40

Suggested Citation

Enke, Benjamin and Zimmermann, Florian, Correlation Neglect in Belief Formation. IZA Discussion Paper No. 7372. Available at SSRN: https://ssrn.com/abstract=2263648

Benjamin Enke (Contact Author)

Harvard University ( email )

1875 Cambridge Street
Cambridge, MA 02138
United States

Florian Zimmermann

University of Bonn ( email )

Regina-Pacis-Weg 3
Postfach 2220
Bonn, D-53012
Germany

Register to save articles to
your library

Register

Paper statistics

Downloads
67
Abstract Views
508
rank
133,546
PlumX Metrics