Innovation, Stock Market Feedback and Good Idiosyncratic Volatility

We theoretically and empirically analyze information generation by stock markets on economic prospects of innovations and the resultant feedback effect on firm-level innovation-related investment (IRI). By modeling the unique aspects of firm-specific and systematic drivers of innovation profits, we derive a positive relation of idiosyncratic volatility of stock returns (IVOL) to the response rate of subsequent IRI generally, and to future stock returns under technological conditions that are more applicable to big innovative firms. Empirically, we find strong and robust support. High IVOL in innovative firms may thus reflect a more intense feedback effect, resulting in increased efficiency of IRI.