The Perception of Dependence and Investment Decisions

We study the perception of dependence between asset returns and its impact on investment decisions. Our findings suggest that, while changes in dependence are not neglected, correlation does not properly capture investors' perception of dependence. In several laboratory experiments we vary dependence between two assets. When dependence is linear, participants understand it and consistently diversify less at higher correlations. However, when we vary non-linear dependence---increasing dependence in extreme returns while decreasing dependence in moderate returns---most participants do not understand dependence in extreme returns. Consequently, they diversify less when dependence in moderate returns increases, even if overall correlation decreases due to less dependence in extreme returns. This finding suggests that investors could improve portfolio selection by taking into account biased beliefs about dependence.