The 'Waterfall Illusion' in the Financial Markets: Risk Perception Is Distorted After Prior Exposure to Extreme Risk
51 Pages Posted: 24 Jan 2015 Last revised: 23 Jan 2019
Date Written: January 22, 2019
How do economic agents perceive risk? We address this question through the neuroscience theory of efficient coding, which predicts that after prolonged exposure to extreme risk, risk perception is distorted in a systematic and pervasive fashion. Using a combination of field and laboratory data, we provide strong evidence for this prediction. Market participants systematically underestimate risk after prolonged exposure to high risk, resulting in distortions of asset prices in a highly sophisticated and liquid financial market.
Keywords: neuro-economics, risk perception, efficient coding, normalization, decision making under uncertainty
JEL Classification: D83, D87, G02, G14, G17
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