Salience Theory of Choice Under Risk

Pedro Bordalo, Nicola Gennaioli, Andrei Shleifer

NBER Working Paper No. 16387
Issued in September 2010
NBER Program(s):   AP   CF

We present a theory of choice among lotteries in which the decision maker's attention is drawn to (precisely defined) salient payoffs. This leads the decision maker to a context-dependent representation of lotteries in which true probabilities are replaced by decision weights distorted in favor of salient payoffs. By endogenizing decision weights as a function of payoffs, our model provides a novel and unified account of many empirical phenomena, including frequent risk-seeking behavior, invariance failures such as the Allais paradox, and preference reversals. It also yields new predictions, including some that distinguish it from Prospect Theory, which we test. We also use the model to modify the standard asset pricing framework, and use that application to explore the well-known growth/value anomaly in finance.

Published: Pedro Bordalo & Nicola Gennaioli & Andrei Shleifer, 2012. "Salience Theory of Choice Under Risk," The Quarterly Journal of Economics, Oxford University Press, vol. 127(3), pages 1243-1285.

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An online appendix is available for this publication.

This paper was revised on December 5, 2011

Acknowledgments

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