Effect of the salience theory in asset pricing in a context of uncertainty : US evidence

Abstract

There are a lot of studies about the effect of behavioral elements on financial issues. On the theoretical front one of the most important contributions is Prospect Theory (Kahneman and Tversky, 1979), where the authors postulate that investors derive their utility from gains and losses relative to some reference or benchmark value. According to Bordalo et al. (2012), the Prospect Theory incorporates the assumption that the probability weights people use to make choices are different from objective probabilities. Bordalo et al. (2012) suggest that these weights depend on the actual payoff and their salience. Bordalo et al. (2013) proposed an asset pricing model based on this idea. The present study will test the model presented by Bordalo et al. (2013), in the context of the US stocks and considering the effect of uncertainty. We employ an approach similar to the one used by Coseman and Frehen (2020) in their study about the effect of the Salience Theory in the US stocks. The main difference between the present study and Cosemans and Frehen (2020), is the incorporation of uncertainty as a key element to understand salience effects. About uncertainty, it can be seen that Bachmann et al. (2013) in a study use confidential micro data of the German IFO Business Climate Survey to compare a disagreement-based measure of uncertainty with a qualitative index of the forecast error variance of production expectations, and found that both uncertainty measures are positively correlated. So, the using of non-standard criteria in evaluate the business climate seems to be more important, in relative terms, in a context of high uncertainty. Following Taylor and Thompson (1982), “salience refers to the phenomenon that when one's attention is differentially directed to one portion of the environment rather than to others, the information contained in that portion will receive disproportionate weighting in subsequent judgments". According to Bordalo et al. (2012), Prospect Theory incorporates the assumption that the probability weights people use to make choices are different from objective probabilities. Bordalo et al. (2012) suggest that these weights depend on the actual payoff and their salience. Then, Coseman and Frehen (2020) study the effect of the Salience Theory in the US stocks, in order to analyze this idea in an empirical context. They found significative results in a sense that, according to their study, Salience Theory actually has an effect on stock pricing