Probability distortions, collectivism, and international stock prices

Abstract

There are substantial differences in the return premia due to probability distortions in individualist and collectivist cultures. Consistent with the substantially lesser degree of probabilistic thinking in collectivist cultures documented by the psychology literature, probability-distortion-related return premia are substantially higher there than in individualist cultures. Our methodology applies a novel composite probability distortion (CPD) score based on cumulative prospect theory and salience theory. This measure is priced among all size groups in the cross-section of international stock returns: lowCPD-score stocks are underpriced while those with high scores appear overpriced. Collectivism is the main driver of differences in the CPD premium across countries and U.S. states.