How Your Brain’s “Break-Even” Bias Creates Mispricings

Investors often talk about cutting losses and letting winners run. But what if our natural psychological tendencies do exactly the opposite—and create predictable patterns that savvy investors can exploit?

Jihoon Goh, Suk-Joon Byun, and Donghoon Kim, authors of the study “Salience Theory and Stock Returns: The Role of Reference-Dependent Preferences,” published in the January 2026 issue of Research in International Business and Finance, revealed how two powerful behavioral forces—our attraction to dramatic stock movements and our desperate desire to “break even” after losses—combine to create systematic mispricing in the stock market.

What the Researchers Examined

Salience theory suggests that investors find assets with salient upsides appealing and those with salient downsides unappealing. The authors investigated a phenomenon called the “salience effect” in stock returns. This effect occurs when investors are drawn to stocks with eye-catching historical performance—those with dramatic daily gains that stand out in their memory. According to salience theory, our cognitive limitations cause us to overweight these salient experiences when making investment decisions. The result is that stocks with high (low) salience values, often driven by salient past returns, tend to be overvalued (undervalued), which results in negative (positive) abnormal future returns. This “salience effect” highlights the impact of cognitive biases on stock valuation and challenges traditional notions of market efficiency.”

The researchers didn’t just look at salience in isolation. Instead, they examined how this effect interacts with investors’ reference points—specifically, whether investors are sitting on gains or losses relative to their purchase price.

Using data from U.S. stocks spanning nearly six decades (1962-2020), they constructed a “salience theory value” for each stock that measured how attention-grabbing its past daily returns were. They then analyzed how this measure predicted future returns, crucially separating stocks where investors had capital gains from those where investors had capital losses.

The Key Findings

The results paint a clear picture of how behavioral biases distort stock prices:

1. The Salience Effect is Reference-Dependent

The salience effect isn’t constant—it depends critically on whether investors are “in the red” or “in the black”:

Among stocks with previous losses, high-salience stocks underperformed low-salience stocks by a stunning 2.00% per month in equal-weighted portfolios.
Among stocks with previous gains, the salience effect essentially disappeared or even reversed.

2. The Break-Even Effect Amplifies Mispricing

Why this dramatic difference? The researchers explain it through the “break-even effect”—after experiencing losses, investors become risk-seeking, desperately chasing stocks that offer the possibility of recovering their losses. High-salience stocks, with their dramatic upside potential, become irresistible to these investors, creating a perfect storm: elevated demand drives up prices of high-salience stocks among the loss group, leading to overvaluation and subsequent poor returns.

3. Individual Investors Drive the Pattern

The effect was strongest among:

Stocks with low institutional ownership (more retail investor involvement).
Overpriced stocks with limited short-selling opportunities.
Periods of high investor sentiment, market volatility, or uncertainty.

This suggests that less sophisticated investors are the primary drivers of this mispricing.

4. The Effect is Pervasive

While many behavioral anomalies disappear in value-weighted portfolios (dominated by large stocks), this salience-reference point interaction remained significant even for bigger companies. Among stocks with previous losses, the pattern held regardless of portfolio weighting. And results were similar in developed markets stocks.

5. The Asymmetry of Mispricing: Overvaluation Dominates Undervaluation

The mispricing pattern revealed by this research isn’t symmetric. High-salience stocks show substantial overpricing following prior losses, while low-salience stocks exhibit relatively weak underpricing after prior gains. This asymmetry exists because limits to arbitrage (short-sale constraints) prevent sophisticated investors from fully correcting overpriced stocks—they can’t easily bet against the overvaluation. However, no such barriers exist on the buy side, allowing arbitrageurs to more readily exploit any undervaluation of low-salience stocks during gain periods. The practical implication is clear: the overpricing trap for high-salience stocks after losses represents a more severe and persistent form of mispricing than its counterpart. This makes the combination of being underwater on positions while chasing exciting, volatile stocks particularly hazardous for investors.

Investor Takeaways

1. Recognize Your Own Biases

Are you sitting on losses and finding yourself drawn to volatile stocks with dramatic price movements? If so, you might be falling victim to the pattern identified in this research. Chasing excitement after losses is precisely when you’re most vulnerable to overpaying. Being especially cautious during high-sentiment periods when these biases intensify.

2. Mental Accounting Matters

The research underscores how dangerous it can be to evaluate each investment in isolation relative to your purchase price. This “mental accounting” leads to poor decisions like holding losers too long and taking excessive risks to break even. Instead, evaluate your entire portfolio objectively.

3. Volatility Isn’t Always Your Friend

Stocks with dramatic daily price swings might feel exciting, especially when you’re trying to recover losses, but this research shows they’re often overpriced for exactly that reason.

4. Market Conditions Amplify Mistakes

The interaction between salience and capital losses becomes even more pronounced during:

Periods of high market sentiment (when optimism runs high).
Times of elevated volatility or uncertainty.
Market environments that discourage short selling.

During these periods, be especially vigilant about the stocks you’re attracted to and why.

The Bottom Line

This research reveals how two powerful psychological forces—our attraction to salient events and our reference-dependent preferences—combine to create predictable patterns of mispricing. When investors are underwater on their positions, their desperation to break even makes them systematically overpay for exciting, volatile stocks.

The best defense? Awareness. Recognize when you’re making decisions based on your unrealized losses rather than fundamental value. Understand that the stocks that feel most appealing when you’re trying to recover losses are often exactly the ones you should avoid.

In investing, as in life, sometimes the most important thing isn’t getting back to where you started—it’s making the best decision from where you are now.

Larry Swedroe is the author or co-author of 18 books on investing, including his latest Enrich Your Future.