Salience and Asset Prices

In Bordalo, Gennaioli, and Shleifer (2012a)— henceforth, BGS (2012a)—we described a new approach to choice under risk that we called salience theory. In comparisons of risky lotteries, we argued, individuals’ attention is drawn to those payoffs which are most different or salient relative to the average. In making choices, individuals overweight these salient payoffs relative to their objective probabilities. A simple formalization of such salience-based probability weighting provides an intuitive account of a variety of puzzling evidence in decision theory, such as Allais paradoxes and preference reversals. Salience theory naturally lends itself to the analysis of the demand for risky assets. After all, risky assets are lotteries evaluated in a context described by the alternative investments available in the market. An asset’s salient payoff is naturally defined as one most different from the average market payoff in a given state of the world. We present a simple model of investor choice and market equilibrium in which salience influences the demand for risky assets. This model accounts for several time series and cross-sectional puzzles in finance in an intuitive way, based on its key implication that extreme payoffs receive disproportionate weight in the market valuation of assets. We focus on four well known puzzles. First, salient thinking leads to a preference for assets characterized by the possibility of high, salient payoffs that are overweighted by investors. One Salience and Asset Prices