The Perception of Dependence and Investment Decisions

67 Pages Posted: 18 Apr 2016

See all articles by Michael Ungeheuer

Michael Ungeheuer

Aalto University School of Business

Martin Weber

University of Mannheim - Department of Banking and Finance

Multiple version iconThere are 3 versions of this paper

Date Written: March 2016

Abstract

We study the perception of dependence between asset returns and its impact on investment decisions. Our findings suggest that, while changes in dependence are not neglected, correlation does not properly capture investors' perception of dependence. In several laboratory experiments we vary dependence between two assets. When dependence is linear, participants understand it and consistently diversify less at higher correlations. However, when we vary non-linear dependence -- increasing dependence in extreme returns while decreasing dependence in moderate returns -- most participants do not understand dependence in extreme returns. Consequently, they diversify less when dependence in moderate returns increases, even if overall correlation decreases due to less dependence in extreme returns. This finding suggests that investors could improve portfolio selection by taking into account biased beliefs about dependence.

Keywords: Biased Beliefs, Correlation Neglect, Dependence, Diversification, Investment Decisions, Risk Taking

JEL Classification: C91, G02, G11

Suggested Citation

Ungeheuer, Michael and Weber, Martin, The Perception of Dependence and Investment Decisions (March 2016). CEPR Discussion Paper No. DP11188. Available at SSRN: https://ssrn.com/abstract=2766483

Michael Ungeheuer (Contact Author)

Aalto University School of Business ( email )

P.O.Box 21210
Aalto, 00076
Finland

HOME PAGE: http://sites.google.com/site/ungeheuermichael/

Martin Weber

University of Mannheim - Department of Banking and Finance ( email )

D-68131 Mannheim
Germany
+49 621 181 1532 (Phone)
+49 621 181 1534 (Fax)

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