Research seminar by Erik Eyster (LSE): «Correlation Neglect in Financial Decision-Making»
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| Erik Eyster |
Venue: Pokrovski Bulvar, 11, Room Zh-822
Lecturer: Erik Eyster (LSE)
Theme: «Correlation Neglect in Financial Decision-Making» (Erik Eyster and Georg Weizsaecker)
Abstract: In many arenas, good decision-making requires the consideration of correlation. Notably, optimal portfolio theory depends upon a sophisticated understanding of the correlation between financial assets. In this paper, we use a sequence of portfolio-allocation problems to examine people’s understanding of correlation 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—but differ only in the assets’ correlation. While any outcome-based theory of choice makes the same prediction across paired problems, the subjects behave very differently across pairs. We find evidence for correlation neglect—people treat correlated variables as uncorrelated—as well as for the simple “1/n heuristic”—investing half of wealth in each of two assets.