Salience Theory and Stock Returns

We present empirical evidence on the asset pricing implications of the salience theory developed by Bordalo, Gennaioli, and Shleifer (2012). In our model, investors overweight (underweight) returns in salient (non-salient) states when computing expected returns based on past returns. Due to this salience-based probability weighting, investors are attracted to stocks with salient upsides. The excess demand for these stocks causes them to become overvalued and to earn low subsequent returns. Conversely, stocks with salient downsides are undervalued and earn high future returns. Using a large cross-section of U.S. stocks, we provide strong empirical support for these theoretical predictions. Consistent with a behavioral interpretation of our results, we find that the impact of salience on returns is stronger among stocks with larger ownership by individual investors and more severe limits to arbitrage. Finally, we show that the effect of salience on stock returns is distinct from other known determinants of expected returns, such as idiosyncratic volatility, liquidity, reversal, momentum, and skewness.