The 'Waterfall Illusion' in Financial Markets: How Risk Perception Is Distorted After Exposure to Extreme Risk

Abstract

How do economic agents perceive risk? We address this question through the neuroscience
theory of adaptive normalization, which predicts that after prolonged exposure to high
volatility, people perceive moderate volatility as lower than the actual level (and vice versa)
due to adaptation to the high or low volatility environment. Using a combination of field
and laboratory tests, we find strong support for this theory. The evidence suggests that
these neurobiologically-grounded perceptual errors cause distortions of asset prices in
sophisticated and liquid financial markets.

Keywords: behavioral economics, neuro-economics, risk perception, decision making under uncertainty, adaptive normalization, efficient coding

JEL Classification: D87, D91, G41