Correlation Neglect in Portfolio Choice: Lab Evidence

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