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Correlation neglect in financial decision-making

Eyster, Erik and Weizsacker, Georg (2011) Correlation neglect in financial decision-making. Discussion Papers, 1104. DIW, Berlin, Germany.

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Abstract

Good decision-making often requires people to perceive and handle a myriad of statistical correlations. Notably, 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 a sequence of portfolio-allocation problems and find it to be strongly imperfect. Our experiment uses pairs of portfolio-choice problems that have the same asset span|identical sets of attainable returns|and differ only in the assets' correlation. While any outcome-based theory of choice makes the same prediction across paired problems, subjects behave very differently across pairs. We find evidence for correlation neglect|treating correlated variables as uncorrelated|as well as for a form of \1/n heuristic"|investing half of wealth each of the two available assets.

Item Type: Monograph (Discussion Paper)
Official URL: http://www.diw.de/en/diw_01.c.100406.en/publicatio...
Additional Information: © 2011 DIW
Library of Congress subject classification: H Social Sciences > HB Economic Theory
Journal of Economic Literature Classification System: B - Schools of Economic Thought and Methodology > B4 - Economic Methodology > B49 - Other
Sets: Departments > Economics
Collections > Economists Online
Rights: http://www.lse.ac.uk/library/usingTheLibrary/academicSupport/OA/depositYourResearch.aspx
Identification Number: 1104
Date Deposited: 14 Feb 2012 11:26
URL: http://eprints.lse.ac.uk/41888/

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