Differential Ability to Recognize Emerging Developments and Corporate Performance Under Uncertainty

Abstract

Research in psychology and biology shows that individuals differ in their ability to recognize changes in the environment and that these differences arise as an adaptive response to uncertainty. We argue that the said ability is relevant to decision making under uncertainty. We conduct empirical tests in which we infer the ability to recognize emerging developments from the propensity to take costly precautionary actions in the face of uncertainty (we dub it prudence). Using a large sample of U.S.-listed firms over a thirty-year period, we report that (i ) prudent firms exhibit greater long-term profitability than firms that have never taken precautionary actions, (ii ) the positive association between prudence and profitability monotonically increases in uncertainty, (iii ) prudence does not convey any benefits in low-uncertainty environments, and (iv) prudent firms are more responsive to changes in investment opportunities. The results are consistent with the theoretical predictions.

Keywords: Knightian uncertainty, responsiveness, perceived uncertainty, ambiguity, unawareness, decision analysis

JEL Classification: D81, D83