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

How do economic agents perceive risk? We address this question through the neurosciencetheory of adaptive normalization, which predicts that after prolonged exposure to highvolatility, 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 fieldand laboratory tests, we find strong support for this theory. The evidence suggests thatthese neurobiologically-grounded perceptual errors cause distortions of asset prices insophisticated and liquid financial markets