The “Waterfall Illusion” in Financial Markets: Evidence from the Laboratory and the Field

51 Pages Posted: 24 Jan 2015 Last revised: 2 Nov 2021

See all articles by Elise Payzan-LeNestour

Elise Payzan-LeNestour

University of New South Wales; Financial Research Network (FIRN)

Lionnel Pradier

UNSW Australia Business School

Tālis J. Putniņš

University of Technology Sydney (UTS); Stockholm School of Economics, Riga

Date Written: November 1, 2021

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

JEL Classification: D87, D91, G41

Suggested Citation

Payzan-LeNestour, Elise and Pradier, Lionnel and Putnins, Talis J., The “Waterfall Illusion” in Financial Markets: Evidence from the Laboratory and the Field (November 1, 2021). UNSW Business School Research Paper No. 04, 2019, Available at SSRN: https://ssrn.com/abstract=2553526 or http://dx.doi.org/10.2139/ssrn.2553526

Elise Payzan-LeNestour (Contact Author)

University of New South Wales ( email )

Australian School of Business
Sydney, NSW 2052
Australia

HOME PAGE: http://www.elisepayzan.com/

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

Lionnel Pradier

UNSW Australia Business School ( email )

Sydney, NSW 2052
Australia

Talis J. Putnins

University of Technology Sydney (UTS) ( email )

PO Box 123
Broadway
Sydney
Australia
+61 2 9514 3088 (Phone)

Stockholm School of Economics, Riga ( email )

Strelnieku iela 4a
Riga, LV 1010
Latvia
+371 67015841 (Phone)

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