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A New Way to View Asset Pricing
Finance Prof. Nicolae Gârleanu explores the risk of innovation shocks
“Innovation” immediately denotes brilliance and discovery. In the realm of asset pricing, however, innovation can become a risk. Haas School Assistant Professor Nicolae Gârleanu created a financial model that reveals that a “shock” of innovation at a given company decreases human capital in competing companies that do not innovate. Consequently, asset pricing models must factor in the risk of innovation to ensure balance within the market and profit among equity holders, he found.
An infusion of innovation commonly implies increased efficiency, productivity, profits, and competition. In their working paper “The Demographics of Innovation and Asset Returns,” Gârleanu and co-authors Leonid Kogan of MIT and Stavros Panageas of the University of Chicago determined that innovation also constitutes a risk factor for asset pricing.
For example, take Amazon and Barnes & Noble, competing book and music retailers. As computer technology developed, the birth of the Internet served as a shock of innovation. Amazon, as an innovator, built its business online and outperformed Barnes & Noble. Barnes & Noble, originally a brick-and-mortar store, took its time to adopt new technology and sell goods online. As a result, without innovating, Barnes & Noble eventually had to close some stores and lay off workers.
“When innovation is particularly successful, in the context of our model, two things happen: The old firms don’t perform as well and the existing or ‘old’ workers suffer in relative terms,” says Gârleanu. “At the aggregate level, the human-capital risk makes workers reluctant to hold stock of existing firms, since their profits are collectively at risk from new entrants and therefore do poorly precisely when their earning power declines.” The result is both a higher equity premium (low stock prices relative to bond prices) for investors and a lower interest rate in the economy.
“The model also implies that firms that benefit from innovation are more desirable, as they hedge against innovation risk, and therefore have high prices,” Gârleanu further explains. “These firms are actually known as ‘growth’ firms due to their potential for innovation. One widely observed feature of financial markets is that such firms have high ratios of market prices to book prices, and tend to perform more poorly on average than low market-to-book firms, or ‘value’ firms. The paper justifies these empirical findings by explaining why growth firms are less risky than value firms.”
“Innovation correlates when growth firms do well, and high innovation is also a measure for workers,” adds Gârleanu. “The reason why the older workers are disadvantaged is because they can’t ‘insure’ themselves against the risk of innovative times.”
The researchers studied an “overlapping-generations economy.” In this model, as in real life, people join the economy over time.
“If you look at the gross domestic product, when innovation is high, GDP grows. Overall, there is more to consume. However there is a distribution issue. When innovation is high, a disproportionate portion of output goes to the innovators, the young people, at the expense of the older people,” says Gârleanu. “Overall, it’s good but the distribution is such that part of the population is hurt.”
The model does not imply that there is only a small role for experience in the workplace; “old” knowledge is still very important in many industries. “We’re looking at the risk,” Gârleanu says. “It is precisely when innovation is bigger than average that older workers perform more poorly than younger workers.”
The paper concludes that the standard aggregate asset pricing model must be augmented to consider the risk posed by innovation. It suggests that the way to cushion major innovation shocks is investment in growth stocks and potential innovation.