The Perception of Dependence, Investment Decisions, and Stock Prices

82 Pages Posted: 24 Oct 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: October 2016

Abstract

We study how investors perceive dependence between stock returns, how this influences investment decisions and stock prices. Our findings suggest that investors understand differences in dependence, but correlation does not properly capture their perception of dependence. In several laboratory experiments, we show that subjects understand dependence in frequent, moderate returns, but do not understand dependence in infrequent, extreme returns. Consistent with a counting heuristic, they diversify more at lower frequencies of comovement, even if correlation increases due to strong positive dependence in extreme returns. Applying our insights from experiments to 1963-2015 US stock returns, we find that there is a robust return premium for stocks with high frequencies of comovement with the market return. Our findings suggest that dependence between stock returns matters for investors and aggregate market outcomes. They also suggest that investors could improve portfolio selection by taking into account biased beliefs about dependence.

Keywords: Asset Pricing, Biased Beliefs, Correlation Neglect, Dependence, Diversification, Investment Decisions

JEL Classification: C91, G02, G11, G12

Suggested Citation

Ungeheuer, Michael and Weber, Martin, The Perception of Dependence, Investment Decisions, and Stock Prices (October 2016). CEPR Discussion Paper No. DP11585. Available at SSRN: https://ssrn.com/abstract=2858247

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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