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How innovation affects stock prices and returns

(MoneyWatch) Innovation is often a good thing. Among other things, it can make us more productive, create new jobs and industries, and raise the standard of living. Yet innovation also has a dark economic side, which Austrian economist Joseph Schumpeter famously called "creative destruction," that reduces the profits of existing firms and erodes the human capital of older workers.

From an investing perspective, the effect of innovation on returns has been unclear. The authors of the paper "Displacement risk and asset returns" wanted to find out if innovation does indeed have an effect, and they seem to have uncovered a few ways it may affect your portfolio. The conclusion: Innovation creates a risk factor. which they call a "displacement risk factor." Their research also helps explain the equity risk premium and the value premium.

Innovation's effect

Let's consider factory jobs that have been eliminated because technology has automated those processes. Some of those workers may have been doing those jobs for 30 years or more. Once they're displaced, their skills may not qualify them for other readily available jobs. And new technology can affect or even wipe out entire industries. Think of how the automobile impacted buggy manufacturers and how Amazon (AMZN) and eBay (EBAY) are changing the retail industry.

One way to hedge against the risk of a job loss (or loss of investment value as the stock of companies you invest in is hurt by innovation) is to invest in companies that tend to gain more from innovation than their competitors. Although earning power may vanish and you may absorb some losses in your stock portfolio, some of that ground might be made up by seeing investment values rise in companies that are taking advantage of these new technologies.

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However, the paper's authors noted that economic benefits of new technologies aren't always captured by existing companies and their shareholders, but rather by new companies that have created these advancements. In other words, these displaced workers (and investors in existing companies) can't fully hedge against the innovation risk that put them out of a job. Thus, they demand a premium (higher expected return) as compensation for accepting innovation risk.

As a result, the risk of displacement faced by older agents (both workers and companies) is a systemic risk factor that can't be fully diversified away. Because the economic benefits of innovation are captured largely by future innovators, current investors can't use the stock market to fully hedge the risks.

What this means for investing

This helps explain both the equity risk premium and the value premium. In terms of the stock premium (the additional return stocks experience above one-month Treasury bills), innovation shocks cause increased competition, which lowers the value of existing firms. Among companies, innovators are typically growth players, as the market usually considers such enterprises to be healthier and better positioned for future growth. Because innovation shocks command a premium price for risk and value stocks are more exposed to innovation shocks, value stocks must have a higher expected return than growth stocks.

This is a very different explanation for the value premium than has been previously proposed. Most risk-based explanations relate to value stocks having greater exposure to aggregate consumption risk.

The authors contribute to our understanding of the sources of risk for both the equity risk premium and the value premium. One conclusion is that a growth tilt acts as a partial hedge for displacement shock, with the cost of insurance being in the form of foregoing the value premium.

Photo courtesy of Orange County Archives

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