Idiosyncratic Risk, Investment, And Ownership

In frictionless capital market, only the systematic component of risk is relevant for investment decisions. By contrast, idiosyncratic risk should not affect managers’ valuation of investment projects, as long as firm owners are diversified and managers maximize shareholders’ value. However, in reality the capital market is inefficient and firm specific risk has an impact on investment decisions. Our paper indicates that there is a significant negative relationship between idiosyncratic risk and investment for publicly traded firms in China on the basis of managerial risk aversion behavior, using data of A share market from 2003 to 2012. Poorly diversified managers may cut back on investment when uncertainty about the firm’s future prospects increases. Further study indicates that firm ownership property, rather than firm insider ownership is sensitive to the negative relationship between investment and idiosyncratic risk. Firm idiosyncratic risks have larger impact on investment decisions of state-owned firms in China compared to private-owned firms. That is to say, managers from stated-owned firms care more about firm specific risk and are more risk-averse.Our paper is arranged as follows. The first part is an outline and summary of this paper. The second part is a literature review about idiosyncratic risk and firm investment in both Chinese and foreign academic field. The third part is a theoretical review of idiosyncratic risk, firm investment behavior and managerial risk preference. In addition, we provide the change trends of idiosyncratic risk and fixed asset investment in Chinese market. In the fourth part we empirically document that, for publicly traded firms on Chinese A share market, when idiosyncratic risk rises, firm investment falls. What’s more, we find that the ownership property, not the insider ownership is sensitive to investment-idiosyncratic risk. Managers from state-owned firms in China express much more risk aversion when facing increasing firm idiosyncratic risk. Finally, we offer several suggestions from aspects of internal and external corporate governance, as well as competitive market competition. Our study makes a contribution to widen studies of idiosyncratic risk and firm investment. Also, it has a practical significance to improve investment efficiency, optimize resource allocation and build a perfect corporate governance mechanism of publicly traded firms in Chinese market.