The effect of idiosyncratic risk on firm decisions: under-investment or diversification?

Purpose - The purpose of this paper is to investigate the influence of idiosyncratic risk on firm decisions. Design/methodology/approach - By introducing managerial ownership as a key variable, the paper presents a parsimonious model to describe the consequences of idiosyncratic risk on firm decisions. Then the paper uses data from the Chinese stock market, in which the managerial ownership is very low (around 0.02 percent) to examine the model predictions. Findings - The authors find that: first, the negative relation between idiosyncratic risk and firm investment, which is found in prior studies, tends to be insignificant when managerial ownership is very low; second, diversification, as an alternative firm decision to lower risk positively, relates to idiosyncratic risk despite lower managerial ownership; and third, this kind of positive relation is weaker for firms with more managerial incentives when diversification is endogenously modeled. Originality/value - This paper provides new evidence to complement existing studies from developed markets, in which executives hold substantial stakes.