Correlation Neglect in Belief Formation

36 Pages Posted: 6 Dec 2013

Multiple version iconThere are 2 versions of this paper

Date Written: November 29, 2013

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: C910, D030, D830, D840, D400

Suggested Citation

Enke, Benjamin and Zimmermann, Florian, Correlation Neglect in Belief Formation (November 29, 2013). CESifo Working Paper Series No. 4483. Available at SSRN: https://ssrn.com/abstract=2363834

Benjamin Enke

Harvard University ( email )

1875 Cambridge Street
Cambridge, MA 02138
United States

Florian Zimmermann (Contact Author)

University of Bonn ( email )

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

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