Volatility After-Effects: Evidence from the Field

We propose and test the idea that investor perceptions exhibit volatility ‘after-effects’ whereby perceived volatility is distorted after prolonged exposure to extreme volatility levels. Using VIX to measure perceived volatility in S&P 500 stocks, we find evidence of significant perceptual distortions in the aftermath of volatility regimes, consistent with the after-effect theory and recent experimental evidence. These distortions are larger after both stronger and longer volatility regimes, and are absent after volatility changes that are not preceded by extreme volatility levels, consistent with the after-effect theory and inconsistent with alternative explanations. Our study shows that perceptual biases can have a significant distortionary effect on asset prices, even in very actively traded financial securities. JEL classification: D83, D87, G02, G14, G17