Biases in the Perception of Covariance
65 Pages Posted: 15 Aug 2018 Last revised: 7 Dec 2018
Date Written: September 1, 2018
I show that beliefs about covariance exhibit compression towards moderate values. First, I examine investor perceptions of the relation between electricity and natural gas across different seasons and geographies. I find that electricity futures exhibit moderate covariance with natural gas futures despite persistent heterogeneity in the fundamental relation in the spot market. A strategy that trades against this bias generates annualized excess returns of 7.2 percent which is not consistent with channels such as rational Bayesian shrinkage or rational inattention. Second, I find that professional forecasters also exhibit this bias, leading to predictable errors in macroeconomic forecasts. Finally, in an experimental setting that includes finance professionals, I find that participants overestimate the stock market's low covariance with macroeconomic variables and that perceptions of the covariance between individual stock returns and the market are compressed towards moderate values. Further, this bias appears in perceptions of autocorrelation which can help explain existing evidence of investor overreaction to past stock returns and underreaction to macroeconomic news.
Keywords: Asset Pricing, Belief Formation, Commodities, Perception of Covariance
JEL Classification: G02, G12
Suggested Citation: Suggested Citation