Creative Destruction and Asset Prices

Abstract

We relate Schumpeter's notion of creative destruction to asset pricing, thereby offering a novel explanation of size and value premia. We argue that small-value firms must offer higher expected returns to compensate for the risk posed by serendipitous invention activity, whereas large-growth stocks provide protection against creative destruction and receive expected return discounts. A two-factor model that accounts for creative destruction risk effectively explains the cross-sectional return variation of size and book-to-market sorted portfolios. The estimated risk compensations associated with creative destruction are substantial and statistically significant, indicating their relevance for asset pricing.

Keywords: creative destruction, asset prices, size premium, size premium, invention activity

JEL Classification: G10, G12