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

Payzan-LeNestour, Elise; Pradier, Lionnel; Putniņš, Tālis J.

doi:10.2139/ssrn.2553526

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

UNSW Business School Research Paper No. 04

51 Pages Posted: 24 Jan 2015 Last revised: 23 Jan 2019

See all articles by Elise Payzan-LeNestour

Elise Payzan-LeNestour

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

Tālis J. Putniņš

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

Date Written: January 22, 2019

Abstract

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

Suggested Citation: Suggested Citation

Payzan-LeNestour, Elise and Pradier, Lionnel and Putnins, Talis J., The 'Waterfall Illusion' in the Financial Markets: Risk Perception Is Distorted After Prior Exposure to Extreme Risk (January 22, 2019). UNSW Business School Research Paper No. 04. Available at SSRN: https://ssrn.com/abstract=2553526 or http://dx.doi.org/10.2139/ssrn.2553526