Belief Dispersion and Investment Allocation

49 Pages Posted: 24 Aug 2014

See all articles by Ding Ding

Ding Ding

University of Toronto - Department of Economics

Date Written: August 15, 2014

Abstract

I analyze the effect of belief differences among investors in equity markets on corporate investment composition. When some investors have highly optimistic beliefs about risky projects relative to the average beliefs, firms rationally respond by allocating investment to riskier projects to exploit the belief dispersion: firms increase relative shares of investment in Research & Development (R&D) and Mergers & Acquisitions (M&A), and decrease the investment share of physical capital expenditure (CAPX). A one standard deviation increase in belief dispersion raises investment shares of R&D and M&A by 4.37% and 1.31%, respectively, and reduces the share in CAPX by 5.67%. This effect remains and even becomes amplified when firms experience positive return shock to CAPX -- a case in which more investment in CAPX would be expected. To establish a causal relationship, I use mergers of brokerage houses as an exogenous shock to analyst coverage, a change that affects belief dispersion. My results show that belief dispersion in the financial sector can lead to risk-taking behaviour in corporate investment. To explain my results, I build a simple model based on Bolton et al. (2006), in which investors agree to disagree and stock prices reflect the beliefs of the most optimistic investors. In this model, the manager-owners of firms have the option to resell their shares to more optimistic investors, and as a result, shift investment composition towards riskier projects to scale up their resale option.

Keywords: Differences in Beliefs, Corporate Investment, Resource Allocation, Productivity Growth

JEL Classification: G14, G31

Suggested Citation

Ding, Ding, Belief Dispersion and Investment Allocation (August 15, 2014). 27th Australasian Finance and Banking Conference 2014 Paper. Available at SSRN: https://ssrn.com/abstract=2485444 or http://dx.doi.org/10.2139/ssrn.2485444

Ding Ding (Contact Author)

University of Toronto - Department of Economics ( email )

150 St. George Street
Toronto, Ontario M5S 3G7
Canada

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