Innovation and stock market performance: A model with ambiguity-averse agents

Abstract

Empirical evidence on stock prices shows that firms investing successfully in radical innovation experience higher stock returns. This paper provides a model that sheds light on the relationship between the degree of firm innovativeness and stock returns, the movements of which capture expectations on firm’s profitability and growth. The model is grounding on Neo-Schumpeterian growth models and relies on the crucial assumption of radical innovation, characterized by “ambiguity” or Knightian uncertainty: due to its uniqueness and originality, no distribution of probability can be reasonably associated with radical innovation success or failure. Different preferences (α-maxmin, Choquet) are here compared. Results show that the assumption of ambiguity-aversion is crucial in determining higher returns in the presence of radical innovation and that the specific definition of expected utility shapes the extent of the returns. This result holds also in the case of endogenous innovation; risk attitude plays no role.