We develop a theory of innovation waves, investor sentiment, and merger activity based on uncertainty aversion. Investors must typically decide whether to fund an innovative project with very limited knowledge of the odds of success, a situation best described as “Knightian uncertainty.” We show that uncertainty-averse investors are more optimistic on an innovation if they can also make contemporaneous investments in other innovative ventures. This means that uncertainty aversion makes investment in innovative projects strategic complements, which results in innovation waves. Innovation waves occur in our economy when there is a critical mass of innovative companies and are characterized by strong investor sentiment, high equity valuation in the technology sector, and “hot” IPO and M&A markets. We also argue that M&A promotes innovative activity and leads to greater innovation rates and firm valuations.
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