Investors Systematically Misread Correlated Signals, Wharton Research Finds

Investors Systematically Misread Correlated Signals, Wharton Research Finds

Investors routinely make a fundamental error when processing market information—treating related signals as independent when they're actually correlated—according to new research from Wharton professor Jessica Wachter that could explain persistent patterns in U.S. stock market returns.

The phenomenon, which Wachter calls "correlation neglect," represents a behavioral blind spot with direct implications for CFOs managing treasury operations, buyback timing, and capital allocation decisions. When multiple pieces of information about a company or market sector stem from the same underlying factor, investors often fail to recognize this connection and overreact to what appears to be independent confirmation.

Wachter, working with co-author Hongye Guo, published the findings in a paper titled "Correlation Neglect in Asset Prices" on February 10. The research challenges a core assumption in traditional finance theory: that investors process information efficiently.

The paper reveals a "striking pattern" in U.S. stock market returns tied to this behavioral quirk, though the source material doesn't specify the exact magnitude or timeframe of the pattern. The research suggests that what appears to be multiple independent signals confirming a market view may actually be different manifestations of the same underlying information—a distinction investors systematically miss.

For finance leaders, the implications extend beyond portfolio management. CFOs who time equity issuances, debt offerings, or major capital expenditures based on market signals could be making decisions on information they've inadvertently double-counted. When analyst upgrades, positive news flow, and momentum indicators all stem from the same fundamental shift, treating them as separate confirmations can lead to overconfidence in market timing.

The research adds to a growing body of work on behavioral finance that has practical applications for corporate treasury functions. Unlike traditional market efficiency theories that assume rational information processing, Wachter's work suggests that even sophisticated investors fall prey to correlation neglect—meaning the phenomenon affects institutional decision-making, not just retail investor behavior.

Wachter, whose research focuses on asset pricing and behavioral finance, has previously explored how psychological biases affect market outcomes. This latest paper extends that work by identifying a specific mechanism through which information processing errors translate into observable market patterns.

The research arrives as finance leaders increasingly grapple with information overload from multiple data sources, AI-generated insights, and real-time market feeds. The correlation neglect framework suggests that more information doesn't necessarily lead to better decisions if investors can't properly assess which signals are truly independent.

For CFOs evaluating market conditions for major financial decisions, the research implies a need for more rigorous analysis of information sources. The question isn't just whether multiple indicators point in the same direction, but whether those indicators are genuinely independent or merely different views of the same underlying factor.

The paper was published as part of Wharton's ongoing research into behavioral phenomena in financial markets, a field that has gained prominence as traditional efficient market theories have struggled to explain certain persistent anomalies in asset prices.