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

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: 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

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

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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