It tales a cool head to invest. A firm’s decision to build up capacity or spend cash on research pays out tomorrow but must be paid for today. That makes investment returns uncertain, influenced by factors — from oil prices to politics — that firms cannot control. With rich-world investment rates looking anaemic, many wonder why big firms are hoarding cash rather than putting the money to work. According to new research, doubts about the future, some of them self-inflicted, are a likely cause.
Common sense suggests that doubt might dull investment. But in some cases uncertainty might spur investment too, as an influential 1996 paper argued. The authors’ first observation was that investment — building a house to sell, say — takes years. The protracted “time to build” means that if property prices shoot up, only the builders who started work years ago benefit. In addition, since long-term projects can often be shelved or sold while under way, downside risks are limited. In other words, the potential benefits of investment in such circumstances exceed the potential costs, making investment a rational choice despite the unknowns.
Testing such theories requires an empirical calculation of the relationship between investment and uncertainty. Yet measuring uncertainty is tricky, as is untangling it from the decision to invest. Some investments — splashing out on a pricey advertising campaign, or buying a rival firm — create uncertainty of their own. In other cases a big investment can reduce worries about where a firm is headed. Because the relationship is two-way, with investment and uncertainty influencing one another, simple correlations of the two variables can jumble the effects.
In a 2007 paper, Nick Bloom of Stanford University, Stephen Bond of Oxford and John Van Reenen of the London School of Economics showed one means of avoiding this “reverse causality”. They took data for a sample of 672 British manufacturing firms between 1972 and 1991, and turned to stock-price volatility as their measure of uncertainty. When looking at investment in a given year, they use previous years’ uncertainty in their analysis. The logic is that past uncertainty tends to predict current uncertainty pretty well: there is more doubt about some firms than others. But historic volatility cannot be influenced by a firm’s current investment decisions, making it a clean measure. The analysis reveals that as uncertainty rises, firms cut investment rates and respond less to investment opportunities.
A paper published this year relies on more timely data. Luke Stein of Arizona State University and Elizabeth Stone of Analysis Group, a consultancy, study 3,965 American firms between 1996 and 2011. They first collect data on options: contracts that give the right to buy and sell stocks in the future. Since options prices represent traders’ estimates of future stock values, a wider spread between the price of a share when the option is sold and the one at which it can be exercised indicates greater uncertainty about where a firm is heading. The data allow the researchers to work out the future “implied volatility” for each firm.