The Role of Uncertainty in Investment: An Examination of Competing Investment Models Using Commercial Real Estate Data

Abstract

Neoclassical investment decision criteria suggest that only the systematic component of total uncertainty affects the rate of investment, as channeled through built asset price. Alternatively, option-based investment models suggest a direct role for total uncertainty in investment decision making. To sort out uncertainty's role in investment, we specify and empirically estimate a structural model of asset market equilibrium. Commercial real estate time series data with two distinct measures of asset price and uncertainty are used to assess the competing investment models. Empirical results generally favor predictions of the option-based model, and hence suggest that irreversibility and delay are important considerations to investors. Our findings also have implications for macroeconomic policy and for forecasts of cyclical investment activity.

JEL Classification: E3, E6, G1, L7, R1