A Theory of Misperception in a Stochastic Dominance Framework and its Application to Structured Financial Products

In this paper, the mechanism of misperception leading retail investors to investment choices, which are not the most profitable, is studied in a stochastic dominance framework from a theoretical perspective and supported by an extensive numerical analysis. The theoretical contribution of the paper consists in the introduction of a specific definition of stochastic dominance, to capture 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 instrument. 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 behavioral finance-type arguments provide insights on the interpretation of the obtained results.