Salience, Fundamentals, and Mispricing

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.