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

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