Georg Weizsäcker, Erik Eyster
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 between 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, the subjects behave very differently across pairs. We find evidence for correlation neglect - people treat correlated variables as uncorrelated - as well as for a form of "1/n heuristic" - people invest half of wealth in each of two available assets.
JEL-Classification: B49
Keywords: portfolio choice, correlation neglect, 1/n heuristic, biases in beliefs
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