Creative Destruction and Asset Prices

Abstract

We relate Schumpeter’s notion of creative destruction to asset pricing, thereby offering a novel explanation of size and value premia. We argue that small-value firms are more likely to be destroyed by serendipitous invention activity, and investors demand higher expected returns for bearing that risk. Large-growth stocks provide protection against creative destruction, so they receive expected return discounts. An ICAPM that accounts for creative destruction risk explains a considerable part of the cross-sectional return variation of size- and book-to-market-sorted portfolios. The estimated risk compensations associated with creative destruction are economically and statistically significant.