Salience Theory and Stock Prices: Empirical Evidence

Abstract

We present evidence on the asset pricing implications of salience theory. In our model, investors overweight salient past returns when forming expectations about future returns. Consequently, investors are attracted to stocks with salient upsides, which are overvalued and earn low subsequent returns. Conversely, stocks with salient downsides are undervalued and yield high future returns. We find empirical support for these predictions in the cross section of U.S. stocks. The salience effect is stronger among stocks with greater limits to arbitrage and during high-sentiment periods. Our results are not explained by common risk factors, return reversals, lottery demand, and attention-grabbing news events.

Keywords: salience theory, probability weighting, asset pricing, return predictability

JEL Classification: D03, G11, G12, G14