Salience theory and stock returns: The role of reference-dependent preferences

Abstract

Salience theory suggests that investors find assets with salient upsides appealing and those with salient downsides unappealing. Our study shows that this effect is reference-dependent, and particularly strong among stocks with prior capital losses. Using a reference-dependent preference framework, we find that investors with prior losses tend to prefer high-salience stocks, reflecting a risk-loving behavior. This salience effect is pronounced in loss regions, muted or reversed in gain regions, and more pronounced among stocks with low institutional ownership and high arbitrage risk, which aligns with individual investor behavior. The effect is amplified during periods of positive-sentiment, high market volatility, and high uncertainty. Our findings are validated through robustness tests and subsample analyses.