Salience, Fundamentals, and Mispricing

Abstract

This paper suggests that mispricing occurs due to a phenomenon known as salience bias. Salience bias arises when investors focus too much on salient payoffs, such as short-term gains, and ignore the underlying financial health of the companies. Salience bias comes into play when investors pay excessive attention to firms with salient-upsides return but weak fundamentals, leading to overpricing of stocks and lower expected returns. Conversely, when investors pay insufficient attention to firms with salient-downsides return but strong fundamentals, stocks may be underpriced, resulting in higher expected returns. This paper also indicates that the uncertainty of stocks has amplification effects on salience bias and the predictive ability of salience bias is stronger when uncertainty is greater.

Keywords:

• Fundamental
• limited attention
• mispricing
• salience theory
• asset pricing

JEF classification:

• G12
• G14
• G17
• G41

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1 Wind information Inc. (Wind) is the largest and most prominent financial data provider in China. Wind serves 90% of China’s financial institutions and 70% of the Qualified Foreign Institutional Investors (QFII) operating in China.

2 The distortion factor ${\omega }_k$ does not depend directly on its probability, states with lower probabilities are relatively more distorted.

3 If $\delta$=1, the weight ${\omega }_k$ is equal to 1 for all group. This is the case of a rational investor. If $\delta <$1, the investor over-weight salient returns at the expense of the non-salient ones. When $\delta \to 0,$ the salient thinker considers only a most salient return and neglects all other returns.

4 There are currently more than three thousand stocks in China’s A-share market. The method in CF (2021) can only calculate the effective salience weight for the top 300 salient stocks, while the salience weight for the remaining stocks is all zero, which is a very large measurement error.