IDEAS home Printed from https://ideas.repec.org/a/eee/jfinec/v143y2022i3p1316-1343.html
   My bibliography  Save this article

Outlier blindness: A neurobiological foundation for neglect of financial risk

Author

Listed:
  • Payzan-LeNestour, Elise
  • Woodford, Michael

Abstract

How do people record information about the outcomes they observe in their environment? Building on a well-established neuroscientific framework, we propose a model in which people are hampered in their perception of outcomes that they expect to seldom encounter. We provide experimental evidence for such “outlier blindness” and discuss how it provides a microfoundation for neglected tail risk by investors in financial markets.

Suggested Citation

  • Payzan-LeNestour, Elise & Woodford, Michael, 2022. "Outlier blindness: A neurobiological foundation for neglect of financial risk," Journal of Financial Economics, Elsevier, vol. 143(3), pages 1316-1343.
    • Handle: RePEc:eee:jfinec:v:143:y:2022:i:3:p:1316-1343
    DOI: 10.1016/j.jfineco.2021.06.019
    as

    Download full text from publisher

    File URL: http://www.sciencedirect.com/science/article/pii/S0304405X21002890
    Download Restriction: Full text for ScienceDirect subscribers only
    File URL: https://libkey.io/10.1016/j.jfineco.2021.06.019?utm_source=ideas
    LibKey link: if access is restricted and if your library uses this service, LibKey will redirect you to where you can use your library subscription to access this item
    ---><---

    As the access to this document is restricted, you may want to search for a different version of it.

    References listed on IDEAS

    as
    1. Nicola Gennaioli & Andrei Shleifer & Robert Vishny, 2015. "Neglected Risks: The Psychology of Financial Crises," American Economic Review, American Economic Association, vol. 105(5), pages 310-314, May.
    2. Gabaix, Xavier & Laibson, David, 2017. "Myopia and Discounting," CEPR Discussion Papers 11914, C.E.P.R. Discussion Papers.
    3. Aldo Rustichini & Katherine E. Conen & Xinying Cai & Camillo Padoa-Schioppa, 2017. "Optimal coding and neuronal adaptation in economic decisions," Nature Communications, Nature, vol. 8(1), pages 1-14, December.
    4. Levon Barseghyan & Francesca Molinari & Ted O'Donoghue & Joshua C. Teitelbaum, 2013. "The Nature of Risk Preferences: Evidence from Insurance Choices," American Economic Review, American Economic Association, vol. 103(6), pages 2499-2529, October.
    5. Botond Kőszegi & Matthew Rabin, 2006. "A Model of Reference-Dependent Preferences," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 121(4), pages 1133-1165.
    6. Bryan Kelly & Hao Jiang, 2014. "Editor's Choice Tail Risk and Asset Prices," The Review of Financial Studies, Society for Financial Studies, vol. 27(10), pages 2841-2871.
    7. Léon Tremblay & Wolfram Schultz, 1999. "Relative reward preference in primate orbitofrontal cortex," Nature, Nature, vol. 398(6729), pages 704-708, April.
    8. Stefano Giglio & Matteo Maggiori & Johannes Stroebel & Stephen Utkus, 2020. "Inside the Mind of a Stock Market Crash," CESifo Working Paper Series 8334, CESifo.
    9. Pedro Bordalo & Nicola Gennaioli & Andrei Shleifer, 2012. "Salience Theory of Choice Under Risk," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 127(3), pages 1243-1285.
    10. Nicholas Barberis & Ming Huang, 2008. "Stocks as Lotteries: The Implications of Probability Weighting for Security Prices," American Economic Review, American Economic Association, vol. 98(5), pages 2066-2100, December.
    11. Matthew Rabin, 2013. "An Approach to Incorporating Psychology into Economics," American Economic Review, American Economic Association, vol. 103(3), pages 617-622, May.
    12. Kumar, Alok & Page, Jeremy K. & Spalt, Oliver G., 2011. "Religious beliefs, gambling attitudes, and financial market outcomes," Journal of Financial Economics, Elsevier, vol. 102(3), pages 671-708.
    13. Botond Koszegi & Adam Szeidl, 2013. "A Model of Focusing in Economic Choice," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 128(1), pages 53-104.
    14. Gennaioli, Nicola & Shleifer, Andrei & Vishny, Robert, 2012. "Neglected risks, financial innovation, and financial fragility," Journal of Financial Economics, Elsevier, vol. 104(3), pages 452-468.
    15. Daniel Kahneman & Amos Tversky, 2013. "Prospect Theory: An Analysis of Decision Under Risk," World Scientific Book Chapters, in: Leonard C MacLean & William T Ziemba (ed.), HANDBOOK OF THE FUNDAMENTALS OF FINANCIAL DECISION MAKING Part I, chapter 6, pages 99-127, World Scientific Publishing Co. Pte. Ltd..
    16. Ing-Haw Cheng & Sahil Raina & Wei Xiong, 2014. "Wall Street and the Housing Bubble," American Economic Review, American Economic Association, vol. 104(9), pages 2797-2829, September.
    17. Jakub Steiner & Colin Stewart, 2016. "Perceiving Prospects Properly," American Economic Review, American Economic Association, vol. 106(7), pages 1601-1631, July.
    18. Xavier Gabaix & Parameswaran Gopikrishnan & Vasiliki Plerou & H. Eugene Stanley, 2006. "Institutional Investors and Stock Market Volatility," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 121(2), pages 461-504.
    19. R. David Mclean & Jeffrey Pontiff, 2016. "Does Academic Research Destroy Stock Return Predictability?," Journal of Finance, American Finance Association, vol. 71(1), pages 5-32, February.
    20. Ido Erev & Eyal Ert & Alvin E. Roth, 2010. "A Choice Prediction Competition for Market Entry Games: An Introduction," Games, MDPI, vol. 1(2), pages 1-20, May.
    21. Michael Woodford, 2020. "Modeling Imprecision in Perception, Valuation, and Choice," Annual Review of Economics, Annual Reviews, vol. 12(1), pages 579-601, August.
    22. Roland Bénabou, 2015. "The Economics of Motivated Beliefs," Revue d'économie politique, Dalloz, vol. 125(5), pages 665-685.
    23. Daniel Kahneman, 2003. "Maps of Bounded Rationality: Psychology for Behavioral Economics," American Economic Review, American Economic Association, vol. 93(5), pages 1449-1475, December.
    24. Xavier Gabaix & Parameswaran Gopikrishnan & Vasiliki Plerou & H. Eugene Stanley, 2003. "A theory of power-law distributions in financial market fluctuations," Nature, Nature, vol. 423(6937), pages 267-270, May.
    25. Alok Kumar, 2009. "Who Gambles in the Stock Market?," Journal of Finance, American Finance Association, vol. 64(4), pages 1889-1933, August.
    26. Nicholas Barberis, 2013. "The Psychology of Tail Events: Progress and Challenges," American Economic Review, American Economic Association, vol. 103(3), pages 611-616, May.
    27. Donnelly, Catherine & Embrechts, Paul, 2010. "The Devil is in the Tails: Actuarial Mathematics and the Subprime Mortgage Crisis," ASTIN Bulletin, Cambridge University Press, vol. 40(1), pages 1-33, May.
    28. Michael Woodford, 2012. "Prospect Theory as Efficient Perceptual Distortion," American Economic Review, American Economic Association, vol. 102(3), pages 41-46, May.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. John R. Graham, 2022. "Presidential Address: Corporate Finance and Reality," Journal of Finance, American Finance Association, vol. 77(4), pages 1975-2049, August.
    2. Duffy, Sean & Smith, John, 2024. "The random thickness of indifference," MPRA Paper 122165, University Library of Munich, Germany.
    3. Payzan-LeNestour, Elise & Pradier, Lionnel & Putniņš, Tālis J., 2023. "Biased risk perceptions: Evidence from the laboratory and financial markets," Journal of Banking & Finance, Elsevier, vol. 154(C).
    4. Hertel, Johanna & Igan, Deniz & Smith, John, 2023. "On the dynamics of the responses in Frydman and Jin (2022): Nullius in verba," MPRA Paper 117788, University Library of Munich, Germany.
    5. Sean, Duffy & John, Smith, 2023. "Stochastic choice and imperfect judgments of line lengths: What is hiding in the noise?," MPRA Paper 116382, University Library of Munich, Germany.

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Xavier Gabaix, 2017. "Behavioral Inattention," NBER Working Papers 24096, National Bureau of Economic Research, Inc.
    2. Pedro Bordalo & Nicola Gennaioli & Andrei Shleifer, 2013. "Salience and Consumer Choice," Journal of Political Economy, University of Chicago Press, vol. 121(5), pages 803-843.
    3. Adriani, Fabrizio & Sonderegger, Silvia, 2020. "Optimal similarity judgments in intertemporal choice (and beyond)," Journal of Economic Theory, Elsevier, vol. 190(C).
    4. Francisco Gomes & Michael Haliassos & Tarun Ramadorai, 2021. "Household Finance," Journal of Economic Literature, American Economic Association, vol. 59(3), pages 919-1000, September.
    5. Stephen G Dimmock & Roy Kouwenberg & Olivia S Mitchell & Kim Peijnenburg, 2021. "Household Portfolio Underdiversification and Probability Weighting: Evidence from the Field," The Review of Financial Studies, Society for Financial Studies, vol. 34(9), pages 4524-4563.
    6. Ryan Webb & Paul W. Glimcher & Kenway Louie, 2021. "The Normalization of Consumer Valuations: Context-Dependent Preferences from Neurobiological Constraints," Management Science, INFORMS, vol. 67(1), pages 93-125, January.
    7. Li An & Huijun Wang & Jian Wang & Jianfeng Yu, 2020. "Lottery-Related Anomalies: The Role of Reference-Dependent Preferences," Management Science, INFORMS, vol. 66(1), pages 473-501, January.
    8. Pedro Bordalo & Nicola Gennaioli & Andrei Shleifer, 2012. "Salience Theory of Choice Under Risk," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 127(3), pages 1243-1285.
    9. Shi, Leilei & Wang, Binghong & Guo, Xinshuai & Li, Honggang, 2021. "A price dynamic equilibrium model with trading volume weights based on a price-volume probability wave differential equation," International Review of Financial Analysis, Elsevier, vol. 74(C).
    10. Schneider, C.A.R. & Spalt, Oliver, 2016. "Conglomerate investment, skewness, and the CEO long shot bias," Other publications TiSEM 5d9321e2-35ea-40f9-9eae-4, Tilburg University, School of Economics and Management.
    11. Henderson, Vicky & Hobson, David & Tse, Alex S.L., 2018. "Probability weighting, stop-loss and the disposition effect," Journal of Economic Theory, Elsevier, vol. 178(C), pages 360-397.
    12. Mel Win Khaw & Ziang Li & Michael Woodford, 2017. "Risk Aversion as a Perceptual Bias," NBER Working Papers 23294, National Bureau of Economic Research, Inc.
    13. Hu, Shiyang & Xiang, Cheng & Quan, Xiaofeng, 2023. "Salience theory and mutual fund flows: Empirical evidence from China," Emerging Markets Review, Elsevier, vol. 54(C).
    14. Dessaint, Olivier & Matray, Adrien, 2017. "Do managers overreact to salient risks? Evidence from hurricane strikes," Journal of Financial Economics, Elsevier, vol. 126(1), pages 97-121.
    15. Shi, Yun & Cui, Xiangyu & Zhou, Xunyu, 2020. "Beta and Coskewness Pricing: Perspective from Probability Weighting," SocArXiv 5rqhv, Center for Open Science.
    16. Carolin Bock & Maximilian Schmidt, 2015. "Should I stay, or should I go? – How fund dynamics influence venture capital exit decisions," Review of Financial Economics, John Wiley & Sons, vol. 27(1), pages 68-82, November.
    17. Yokoo, Hide-Fumi & Arimura, Toshi H. & Chattopadhyay, Mriduchhanda & Katayama, Hajime, 2023. "Subjective risk belief function in the field: Evidence from cooking fuel choices and health in India," Journal of Development Economics, Elsevier, vol. 161(C).
    18. Chen Lian & Yueran Ma & Carmen Wang, 2019. "Low Interest Rates and Risk-Taking: Evidence from Individual Investment Decisions," The Review of Financial Studies, Society for Financial Studies, vol. 32(6), pages 2107-2148.
    19. Jondeau, Eric & Zhang, Qunzi & Zhu, Xiaoneng, 2019. "Average skewness matters," Journal of Financial Economics, Elsevier, vol. 134(1), pages 29-47.
    20. Jin, Xiaoye, 2022. "Testing technical trading strategies on China's equity ETFs: A skewness perspective," Emerging Markets Review, Elsevier, vol. 51(PA).

    More about this item

    Keywords

    Tail risk; Imprecise perception; Efficient coding; Adaptation; Decision making under uncertainty; Behavioral finance; Neuroeconomics; Experiments;
    All these keywords.

    JEL classification:

    • C91 - Mathematical and Quantitative Methods - - Design of Experiments - - - Laboratory, Individual Behavior
    • D87 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Neuroeconomics
    • G41 - Financial Economics - - Behavioral Finance - - - Role and Effects of Psychological, Emotional, Social, and Cognitive Factors on Decision Making in Financial Markets

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:eee:jfinec:v:143:y:2022:i:3:p:1316-1343. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Catherine Liu (email available below). General contact details of provider: http://www.elsevier.com/locate/inca/505576 .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.