Financial Econometrics and Empirical Market Microstructure
Risk Myopia and Disruptive Information
How could markets have been so blind for so long? Credit markets appeared to have outsourced credit risk assessment the ratings agencies, who were asleep at the wheel, not to mention conflicted by lucrative subprime bond underwriting fees. Robert
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■2006-1AAA' Absolute Spread Levels
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Schiller (having warned of housing bubble since 2005) attributed this collective denial to groupthink:
Suppose you imagine yourself and a group of experts who seem to have converged on an enlightened opinion which has arguments to support it, and it has prominent influential people saying that. It can be difficult for someone to stand up in that room and air what seem to be half-baked or half-formed doubts about it. It can be kind of damaging to your reputation. (Grove 2008)
Pervasive risk myopia is confirmed by behavioral economics. Cognitive biases limit our ability to rationally assess risk and be open to new information. Well known risk distorting biases include overconfidence, underestimation of small probability events, confirmation bias, and missing new information when overfocusing (Kahneman 2011). Nate Silver discusses these biases in The Signal And The Noise (2012), and observes that they apply to financial professionals and economists just as much as anyone else.
