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Correlation Neglect in Portfolio Choice: Lab Evidence

35 Pages Posted: 10 Feb 2017  

Erik Eyster

London School of Economics & Political Science (LSE) - Department of Economics

Georg Weizsacker

Humboldt University Berlin; DIW Berlin

Date Written: October 28, 2016

Abstract

Optimal portfolio theory depends upon a sophisticated understanding of the correlation among financial assets. In this paper, we examine people’s understanding of correlation using portfolio-allocation problems and find it to be strongly imperfect. Our experiment uses pairs of problems having the same span of assets — identical sets of attainable returns — but different correlations between assets. While expected-utility theory makes the same prediction across paired problems, subjects behave very differently within pairs. We find evidence for correlation neglect — treating correlated variables as uncorrelated — as well as for the “1/n heuristic” — investing half of wealth each of the two available assets.

Keywords: portfolio choice, correlation neglect, 1/n heuristic, biases in beliefs

JEL Classification: B49

Suggested Citation

Eyster, Erik and Weizsacker, Georg, Correlation Neglect in Portfolio Choice: Lab Evidence (October 28, 2016). Available at SSRN: https://ssrn.com/abstract=2914526 or http://dx.doi.org/10.2139/ssrn.2914526

Erik Eyster

London School of Economics & Political Science (LSE) - Department of Economics ( email )

Houghton Street
London WC2A 2AE
United Kingdom

Georg Weizsacker (Contact Author)

Humboldt University Berlin ( email )

Spandauer Str. 1
Berlin, D-10099
Germany

DIW Berlin

Mohrenstr. 58
Berlin
Germany

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