Probability Distortions, Collectivism, and International Stock Prices

We introduce a novel composite probability distortion (CPD) score based on investors’ stock valuations derived from a pure-probability-weighting version of cumulative prospect theory and from salience theory. This measure is strongly and consistently priced in the cross-section of international stock returns: low-CPD-score stocks are underpriced while those with high scores appear overpriced. Individualism is the main driver of differences in the CPD premium across countries and U.S. states. Consistent with the substantially lesser degree of probabilistic thinking in collectivist cultures documented by the psychology literature, we find that the CPD premium is substantially higher in these than in individualist cultures