Advertising, Research and Development, and Capital Market Risk: Higher Risk Firms versus Lower Risk Firms

Article excerpt

1. Introduction

Classical financial theory argues that investors, who make their investment decisions according to the expected utility function, will tend to optimize their risk-reward tradeoff, leading to an equilibrium in which the cross-sectional expected asset returns depend only on the cross-section systematic risks (hereinafter, [beta]-risk). However, recent literature (Lui et al. 2007) considers that [beta]-risk may not account for sufficient explanatory power of the variation in a stock returns because the residuals of the Capital Assets Pricing Model (CAPM) are influenced by these other sources of covariance (Rosenberg 1974), referred to as non-systematic risk (hereinafter, idiosyncratic risk) (1). Ang et al. (2006) find that stocks with high idiosyncratic volatility have low average returns. The above evidence implies that investors should be concerned about risks both from the market returns and from changes in firm's individual intrinsic risk. Therefore, the issue of investigating the components of firm's [beta]-risk and idiosyncratic risk has became a very popular issue among both academics (Ang et al. 2006; Chang, Dong 2006) and practitioners (Lui et al. 2007). For example, Chen (2002) and Ang et al. (2006) show evidence that a firm with higher [beta]-risk has a lower expected return because investors' prospects for the uncertainty of market returns is increased. Lui et al. (2007) indicate that financial analysts have viewed a firm's idiosyncratic risk as an important measure when issuing their rating for the risk of investing in a stock. Without decomposing a firm's total risk into [beta]-risk and idiosyncratic risk, management executives and market participants will not understand how or even whether the operating strategies or components efficiently influence a firm's stock returns risk because a firm's [beta]-risk and idiosyncratic risk may be driven by different reasons.

There is considerable literature in financial studies presenting significantly evidence that the impact of changes in accounting variables such as firm's sales growth can affect a firm's [beta]-risk and idiosyncratic risk (2). Recent marketing studies (Fornell et al. 2006; Singh et al. 2005) show that firms with greater intangible market-based assets will have lower firm returns risk. A firm's returns risk could be decomposed into [beta]-risk and idiosyncratic risk. Regarding [beta]-risk, this study infers that advertising will create intangible market-based assets such as consumer loyalty, which may lead investors to hold their stocks longer (Goetzmann, Peles 1997), and will lower a firm's stock volatilities from market movements, which has a significant negative impact on firm's [beta]-risk. With respect to idiosyncratic risk, or the intrinsic risk that cannot be explained by market movements, investing in intangible market-based assets such as advertising may increase product market demand that stabilizes a firm's operating cash flows, and lowers a firm's idiosyncratic risk. With respect to the relation between R&D and returns risk, Ho et al. (2004) find a significant positive relation between research and development expenditures (R&D) and [beta]-risk, while Xu and Zhang (2004) find a significant positive relation between R&D and total risk. (3) This is because firms may increase the level of uncertainty in their future cash flows by their expenditures on R&D (McAlister et al. 2007). This decreases the predictability of a firm's future income streams (Kothari et al. 2002), which in turn, increases an individual firm's risk. Instead, past research pays less attention to whether changes in a firm's intangible investment, such as advertising and R&D, simultaneously both affects both a firm's [beta]-risk and idiosyncratic risk, which should be a metric of interest to both finance executives and investors (4). The first goal of this paper is to examine the impact of a firm's advertising and R&D on both dimensions of stock returns risk: [beta]-risk and idiosyncratic risk. …