The “Waterfall Illusion” in the Perception of Risk

Abstract

How do economic agents perceive risk? Here we propose a new theory in which 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. We provide evidence that these 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