R&D investments and idiosyncratic volatility: evidence from a quasi-natural experiment

An intriguing phenomenon in the U.S. stock market is that the level of average stock return volatility has increased considerably since the 1960s. We argue that corporate R&D investments provide an explanation for this phenomenon due to the uncertainties of R&D investment payouts and the information asymmetry between firms and investors. We employ a quasi-natural experiment, namely, the changes in state-level R&D tax credits in the U.S. to investigate the effect of R&D investments on idiosyncratic volatility. The results of baseline regressions show that a one-standard-deviation increase in R&D tax credits (user cost of R&D capital) is associated with a 0.013 (0.049) standard-deviation increase (reduction) in idiosyncratic volatility. This finding provides an explanation for the increasing trend in the average stock return volatility over the recent decades.