Abstract
This work deals with the issue of investors’ irrational behavior and financial products’ misperception. The theoretical analysis of the mechanisms driving erroneous assessment of investment performances is explored. The study is supported by the application of Monte Carlo simulations to the remarkable case of structured financial products. Some motivations explaining the popularity of these complex financial instruments among retail investors are also provided. In particular, investors are assumed to compare the performances of different projects through stochastic dominance rules. Unreasonably and in contrast with results obtained by the application of the selected criteria, investors prefer complex securities to standard ones. In this paper, introducing a new definition for stochastic dominance which presents asymmetric property, we provide theoretical and numerical results showing how investors distort stochastic returns and make questionable investment choices. Results are explained in terms of framing and representative effects, which are behavioral finance type arguments showing how decisions may depend on the way the available alternatives are presented to investors.
Highlights
The importance of making choices based on the expected performances of economic and financial variables is out of question and the correct way to do it represents the focus of an endless scientific debate
We refer to stochastic dominance decision rules and, in this respect, we propose a new definition of asymmetric stochastic dominance by considering the investors’ misperception of random amounts
Results imply that if investors erroneously perceive that the probability mass (62.32%) of the complex contract return is concentrated in correspondence of 46.72% in such a way that the most likely final wealth is given buy YT = 1613.92, they select the complex contract in light of the first stochastic dominance criteria
Summary
The importance of making choices based on the expected performances of economic and financial variables is out of question and the correct way to do it represents the focus of an endless scientific debate. Tversky and Kahneman (1986), Birnbaum and Navarette (1998) and Leland (1998) deal with the problem of direct violations and provide an explanation of the motivation driving these violations They propose a behavioral-finance argument grounded on the scarce transparency of how the stochastic dominance rules should be used to order a set of financial projects. This merging constitutes the basis of the misperception mechanism (see Wang and Fishbeck, 2004 for the analysis of the incidence of framing effects on decisions, with a particular reference to prospect theory) It is worth noting the asymmetric behavior of the financial institutions in framing in a more attractive fashion only the complex products.
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