Predicting Investment Shock Waves
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Finance & Accounting Innovation Feb 2, 2012

Predicting Investment Shock Waves

How technological innovations affect risk premiums

Based on the research of

Dimitris Papanikolaou

Major technological advances have the power to shake up the marketplace. As investment shocks, technological innovations do not affect all firms equally. Some firms benefit, while others lose market share. Because of these risks, investors demand a premium for investing in companies that appear unable to adapt to new technologies, argues Dimitris Papanikolaou, an assistant professor of finance at the Kellogg School of Management.

Papanikolaou cites the rise of the Internet as an example of an innovation that produced major winners and losers in the marketplace. Companies that were able to implement the investment shocks and adapt to the Web environment—Amazon, for example—found a new structure and were able to take advantage of the major innovation. Other firms were not able to adapt, and some eventually went out of business, such as Borders. “People buy stock in a firm, and then the next Internet arrives, and they don’t know how the firm will fare in that environment,” Papanikolaou says.

The difference in the ability of companies to take advantage of new advances makes a big difference for investors. For example, investors who bought equity in a bricks-and-mortar bookstore in the 1990s would have found that their investment strategy did not pay off—many bookstores did not adapt to the rise of the Internet. That gave Amazon an opportunity to take substantial market share. “As an investor in those types of firms, I’m afraid that stock prices will go down and demand a higher risk premium,” Papanikolaou says.

In order to benefit from an innovation, a firm must have the means to adopt or implement it.

He adds that the idea of investment shocks has helped scholars understand long-term growth, and that concept has been incorporated into many models used to predict how stock prices will fluctuate. His model is a type of “real business cycle model,” in which market fluctuations are largely explained by shocks to the business environment. The problem with some of these models, Papanikolaou says, is that they attempt to account for the impact of technological innovation by using “disembodied shocks.” In other words, these models assume that the ability to adopt or benefit from innovation is automatic and equal across all firms. In the real world, of course, this is not the case—in order to benefit from an innovation, a firm must have the means to adopt or implement it.

For example, take the case of better computers. People who use models with disembodied shocks assume that the benefits from the new machines fall equally on all companies. But as Papanikolaou explains, “My old laptop is still very slow—it doesn’t go any faster because Intel released a new processor. In order to benefit from this innovation, I need to go out and buy this new computer. It’s not going to magically land on my desk.” That is why his model accounts for the fact that firms will implement technological advances differently, which is an important factor in understanding how they will fare in the wake of an investment shock that affects the whole market.

Value vs. Growth

Another important factor in Papanikolaou’s model is the difference between value firms and growth firms. Based on the results from his model, Papanikolaou argues that investment shocks “benefit producers of capital goods relative to producers of consumption goods, and within each sector, benefit firms with opportunities to invest relative to those that lack growth opportunities.” This results in lower risk premiums for growth firms as compared to risk premiums for value firms, “because they act as hedges for shocks to real investment opportunities,” he reports in the recent paper.

He explains that when a value firm—a firm whose market value is lower than the value of its assets—owns substantial physical assets, the risk is increased that the firm may not be able to efficiently adapt to the next big thing. For example, although Blockbuster owned a lot of stores that rented videotapes, its market value was relatively low because the market perceived that Blockbuster would have trouble adapting to the Internet.

Papanikolaou notes that this fear about Blockbuster turned out to be well founded—Netflix came along and stole its market share. Blockbuster as we knew it is now out of business. When investors buy a value stock like Blockbuster, they run the risk that a Netflix will come along and take that company’s market share. Therefore, investors require a higher rate of return to buy stock in a company like Blockbuster.

Another thing Papanikolaou argues, based on his model, is that when innovations emerge, the economy diverts resources to new investment and away from current consumption. This happens because in the short run, we must all pay a cost to benefit from innovation. “As a result, if I invest in a value firm like Blockbuster, whose value drops when my consumption drops, I am unhappy. In contrast, I like growth firms like Netflix, because they do well when I choose to divert resources away from consumption,” Papanikolaou says.

Understanding what creates stock market movements is very important, Papanikolaou believes. The overall challenge, he notes, is to link stock market prices to the state of the economy, rather than viewing the stock market as something that fluctuates randomly. His model’s findings are a piece of that puzzle.

Related reading on Kellogg Insight

Valuing Possibilities: Investment behavior and stock returns may measure growth opportunities

Liquidity Rules: Manage innovation or risk repeating history

About the Writer
Beverly A. Caley, JD is an independent writer based in Corvallis, Oregon, who concentrates on business, legal, and science topics.
About the Research

Papanikolaou, Dimitris. 2011. “Investment Shocks and Asset Prices.” Journal of Political Economy. 119(4): 639-685.

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