The Perception of Dependence, Investment Decisions, and Stock Prices
87 Pages Posted: 29 Feb 2016 Last revised: 24 Mar 2017
Date Written: March 23, 2017
How do investors perceive dependence between stock returns? And how does their perception of dependence affect investments and stock prices? We show experimentally that investors understand differences in dependence, but not in terms of correlation. Subjects rather assess the frequency of comovement by applying a simple counting heuristic. Consequently, they diversify more when the frequency of comovement is lower even if correlation is higher. Building on our experimental findings, we conduct an empirical analysis of 1963-2015 US stock returns revealing a robust return premium for stocks with high frequencies of comovement with the market return.
Keywords: Biased Beliefs, Dependence, Investment Decisions, Correlation Neglect, Diversification, Asset Pricing
JEL Classification: C91, G02, G11, G12
Suggested Citation: Suggested Citation