Availability Bias And Disaster Imprinting Contribute To Excess Implied Volatility

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 (^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.

Disclosure: Short VIX at time of writing.

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