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Correlation Neglect in Belief Formation

Author

Listed:
  • Enke, Benjamin

    (Harvard University)

  • Zimmermann, Florian

    (IZA and University of Bonn)

Abstract

Many information structures generate correlated rather than mutually independent signals, the news media being a prime example. This paper shows experimentally that in such contexts many people neglect these correlations in the updating process and treat correlated information as independent. In consequence, people's beliefs are excessively sensitive to well-connected information sources, implying a pattern of "overshooting" beliefs. Additionally, in an experimental asset market, correlation neglect not only drives overoptimism and overpessimism at the individual level, but also affects aggregate outcomes in a systematic manner. In particular, the excessive confidence swings caused by correlated signals give rise to predictable price bubbles and crashes. These findings are reminiscent of popular narratives according to which aggregate booms and busts might be driven by the spread of "stories". Our results also lend direct support to recent models of boundedly rational social learning.

Suggested Citation

  • Enke, Benjamin & Zimmermann, Florian, 2013. "Correlation Neglect in Belief Formation," IZA Discussion Papers 7372, Institute of Labor Economics (IZA).
    • Handle: RePEc:iza:izadps:dp7372
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    More about this item

    Keywords

    correlation neglect; beliefs; overshooting; experiments; markets;
    All these keywords.

    JEL classification:

    • C91 - Mathematical and Quantitative Methods - - Design of Experiments - - - Laboratory, Individual Behavior
    • D03 - Microeconomics - - General - - - Behavioral Microeconomics: Underlying Principles
    • D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search; Learning; Information and Knowledge; Communication; Belief; Unawareness
    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
    • D40 - Microeconomics - - Market Structure, Pricing, and Design - - - General

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