How our brains blind us to 'black swan' economic events

Neurobiological factors blind people to making sound investment decisions when markets are hit by large macroeconomic shocks, shows UNSW Business School research.

Unemployed men queued outside a soup kitchen during the Great Depression

Many during the Great Depression missed the fact that a permanent shift had occurred in the world. Image: Shutterstock

The outbreak of coronavirus was and still is an ‘interesting natural experiment’ illustrating how people, particularly investors, initially misinterpret the nature of major unpredictable events (known as black swan events), says Scientia Fellow Elise Payzan-LeNestour, Associate Professor in the School of Banking and Finance at UNSW Business School.

A/Prof. Payzan-LeNestour says people tend to grossly underestimate their importance before eventually readjusting their view – though by which time it may be too late. “Our brain is deceiving us in a pervasive and systematic fashion,” she says.

Her latest co-authored research paper: “Outlier Blindness”: Efficient Coding Generates an Inability to Represent Extreme Values sheds light on the neurobiological foundations of this bias, which is at odds with behavioural patterns previously described in behavioural science. With her collaborator from Columbia University, she calls this bias “outlier blindness”. 

Insights for business and finance  

During the Great Depression, Australia suffered years of high unemployment poverty, low profits, deflation, and lost opportunities for economic growth. But during this time, the government cut spending drastically. As we now know – thanks to Keynesian economics – fiscal contraction only adds fuel to the fire in times of widespread falls in demand. 

If history is anything to go by, Australia needs more government stimulus – not less, inasmuch as the current downturn is not the sign of a temporary crisis but of a permanent shift. The findings by A/Prof. Payzan-LeNestour’s research suggests people tend to grossly underestimate the sheer significance of events like the Great Depression while they are living it, and as a result, they do not react as quickly as they should. 

The theory proposed by A/Prof. Payzan-LeNestour and colleagues also sheds light on investor risk attitudes in the aftermath of COVID-19, which is quite puzzling at first. Recent research provides evidence that on one hand, COVID-19 made investors more risk-averse for a given level of perceived risk (which is quite intuitive; this probably occurred because of increased fear and panic).

On the other hand, COVID-19 decreased investors’ perception of a given level of risk, which is also quite puzzling and one potential explanation for why the S&P 500 has rebounded 32 per cent since late March. Many market observers are calling this ‘a disconnect from the deteriorating fundamentals’, says A/Prof. Payzan-LeNestour.

Why is this?

The theory she proposes predicts exactly such a pattern, which she recently described in detail with co-authors from UNSW and UTS. “Following the extreme volatility of March, investors subsequently underestimated risk, leading to inflated valuations through downward biased discount rates, leading to a market rebound until such time as perceptions revert towards objective measures of risk,” she explains.

So, what is causing investors’ temporary underestimation of risk following their exposure to extreme volatility? “The brain becomes adapted to very high levels of volatility reasonably quickly – so completely crazy levels of volatility can become the new normal,” which she shows in an experimental study.

Insights for all of us

“Awareness of our own perceptual biases may help us become less susceptible to them, even though they are very ingrained,” says A/Prof. Payzan-LeNestour.

“If you are conscious of them, even if part of your brain is still deceiving you, you may be able to adjust your decision-making,” she explains. 

“Ironically, even I (and I’m supposed to know about outlier blindness) was blind to the importance of COVID-19 for months, in the sense that I grossly underestimated its importance and didn’t realise until a few weeks ago that our world will never go back to what it was before,” confesses A/Prof. Payzan-LeNestour. “I guess this reflects the fact that as any scientist, I try to view my own theories with a healthy degree of scepticism.”

She says, hopefully, the dissemination of her research into the neurobiological foundations of investor decision-making will help people anticipate how they are going to react to the next tragedy and correct their view accordingly.