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

49 Pages Posted: 24 Jan 2015 Last revised: 20 Nov 2020

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: June 18, 2020

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

Suggested Citation

Payzan-LeNestour, Elise and Pradier, Lionnel and Putnins, Talis J., The 'Waterfall Illusion' in Financial Markets: How Risk Perception Is Distorted After Exposure to Extreme Risk (June 18, 2020). 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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