MIT Sloan professor finds that innovation creates systematic risk in financial markets

Leonid KoganLeonid Kogan, Nippon Telegraph & Telephone Professor of Management Professor of Finance

CAMBRIDGE, Mass., March 22, 2010 — While innovation benefits the overall economy with increased output, consumption, and wages, it also poses significant risk for older firms and workers, according to MIT Sloan School of Management Professor Leonid Kogan. It increases competitive pressure, reduces profits of existing businesses, and erodes the human capital of older workers. Those workers are less able to adapt to new technologies, which reduces their wages compared to their younger counterparts, he says.

In a recent paper, “The Demographics of Innovation and Asset Returns,” Kogan studies how innovation creates a “displacement risk factor” that negatively impacts older firms and workers. “Innovation benefits most people to some extent, but the benefits aren’t distributed equally. Newer generations have more relevant skills, earn higher wages, and introduce new companies into the market,” he explains. “Older workers don’t benefit as much from the introduction of those new businesses.”

Applying this concept to the measurement of risks and financial returns, Kogan finds that using aggregate data is misleading as it fails to include the displacement risk factor. He says, “In our study, we attempt to revise the way we think about risk and returns in financial markets. Innovation is good for the overall economy, but it does more good for some than for others. We need to understand the allocation of resources across the population and not just rely on the average, aggregate numbers.”

He maintains that economists should consider a cross section of households, following what age cohort they belong to and studying cohort-specific effects on consumption and welfare. “What you will find is that the differences in consumption across households are related to the realized history of returns in financial markets. Whatever proxy for innovation we see in financial markets translates into cross sectional differences in how well households are doing – the older households vs. the newer ones.”

The paper was coauthored by Nicolae Gârleanu of the University of California Berkeley and Stavros Panageas of the University of Chicago Booth School of Business.

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