A theory of misperception in a stochastic dominance framework and its application to structured financial products

We study the mechanism of misperception that leads retail investors to investment choices which are not the most profitable. This mechanism is studied in a stochastic dominance framework from a theoretical perspective and supported by an extensive numerical analysis. Our theoretical contribution is the introduction of a specific definition of stochastic dominance that captures the effects of an asymmetric trend-type misperception. Such a novel conceptualization is consistent with the perspective here adopted, i.e. the misperception is driven by a positive trend affecting the entire set of possible realizations. The financial relevance of the theoretical proposal is highlighted through the paradigmatic case of structured financial products. To this end, we perform a pairwise numerical comparison between investment products to get insights about the inversion of the order of stochastic dominance, leading investors to prefer the less profitable instruments. The critical trend, the value where preferences are reversed, is interpreted as a measure of investors’ misperception and compared with different levels of the volatility. Some behavioural finance-type arguments provide insights on the interpretation of the obtained results. This is a pre-copyedited, author-produced PDF of an article accepted for publication in IMA Journal of Management Mathematics following peer review. The version of record A theory of misperception in a stochastic dominance framework and its application to structured financial products is available online at: https://doi.org/10.1093/imaman/dpw007