Lottery preference, short-sale constraint, and the salience effect: Evidence from China

This paper documents the significant and robust salience theory (ST) effect in China, which differs from the findings in the literature. First, the upside-ST effect from stocks with salient upsides is stronger than the downside-ST effect from stocks with salient downsides; the opposite pattern is documented in the US market. We demonstrate that this pattern is due to strong lottery preference and short-sale constraint in China, where investors are prone to engage in salient thinking when they bet on lottery stocks; meanwhile, short-sale constraint prevents rational investors from correcting salience-induced mispricing. Second, the salience effect remains strong in big stocks and high institutional ownership stocks. Our findings are consistent with the existing evidence that fund managers cater to fund investors' lottery preferences to hold lottery stocks. Our study provides new insights into the sources of the salience effect in China, especially salience's interaction with investor behaviors and the market's institutional characteristics.