Tuesday, November 3, 2009

Availability Bias and Disaster Imprinting

After I dashed off The VIX Spike Conundrum, it occurred to me that there might be some aspects of behavioral finance that have contributed to what is now a full year of continued overestimating of future volatility. I detailed this phenomenon in The Gap Between the VIX and Realized Volatility and is also being reflected in up in a VIX:VXV ratio that has been stuck at unusually low levels from mid-July until last week.

In thinking about the various elements of behavioral finance that impair ‘rational’ decision-making and could contribute to excess implied volatility, one factor that immediately comes to mind is availability bias (nicely summarized in Wikipedia.) The global financial crisis and VIX spikes into the 80s were so vivid and memorable – and so thoroughly discussed in the media – that they are all too easy to recall one year later, even though arguably most of the risks associated with a VIX of 80 have since passed.

I do not think that availability bias is the only explanation for recent excess implied volatility. My working hypothesis – which I do not believe has been addressed by the behavioral finance crowd – is that another factor is as work. I call it “disaster imprinting” for lack of a better name. Disaster imprinting refers to a phenomenon in which the threats of financial and psychological disaster were so severe that they continue to leave a permanent or semi-permanent scar in one’s psyche. Another way to describe disaster imprinting might be to liken it to a low level financial post-traumatic stress disorder.

I will do some additional research to test the disaster imprinting theory, but for now I wanted to throw the idea out and see what others think. Has going to the brink of a global financial meltdown impaired our collective ability to assess future probabilities? If so, how long will this impairment last? As always, all comments are appreciated.

For additional posts on related subjects, readers are encouraged to check out:

Disclosure: Short VIX at time of writing.

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