Risk Aversion and Stochastic Dominance: A Revealed Preference Approach

Theoretically, given a choice over two risky assets with equivalent expected returns, a risk averse expected utility maximizer should choose the second-order stochastically dominant asset. We develop a theoretical framework that allows for decision error, which should decrease in risk aversion. We conduct an experiment using a risk preference elicitation mechanism to identify risk averse individuals and evaluate the frequency that they choose the stochastically dominant of two lotteries. 75.76% of risk averse and 96.15% of very risk averse subjects chose at least 7 out of 10 dominant lotteries. Estimates of the effect of elicited risk aversion on the number of stochastically dominant lotteries chosen are positive and highly significant across specifications. The results suggest risk averse individuals make choices that satisfy stochastic dominance and violations are due, in large part, to decision error, which is decreasing in risk aversion.