Correlation Neglect in Financial Decision-Making

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. (JEL B49)