How to Alleviate Correlation Neglect in Investment Decisions

Abstract

We experimentally study how presentation formats for return distributions affect investors’ diversification choices. We find that sampling returns alleviates correlation neglect and constitutes an effective way to improve financial decisions. When participants get a description of the probabilities for outcomes of the joint return distribution, we confirm the findings of others that investors neglect the correlation between assets in their diversification choices. However, when participants sample from the joint distribution, they change their allocation between two assets in response to a change in their correlation in the predicted direction. The results are robust across two experiments that have participants with varying experience (students versus private investors).This paper was accepted by Manel Baucells, behavioral economics and decision analysis.