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Learning versus Diversification in Project Choice

Listed author(s):
  • Narayanan Subramanian

    (Brandeis University)

  • Nidhiya Menon

    (Brandeis University)

We study the issue of project choice when a risk-averse agent must choose whether to invest in two projects of the same type (focus) or of different types (diversification). Projects of the same type are subject to common type-specific shocks. Hence focusing is more risky within each period, but enables faster learning across periods. Optimal project choice involves balancing these two considerations. We demonstrate how an agent's choice of whether to focus or diversify is related to (i) the speed of learning (ii) the type-specific risk and (iii) his risk- aversion and investment horizon. We show that, contrary to intuition, an increase in type-specific risk may lead to a decrease in diversification. Our theory is applicable to occupational choice within households, project choice under group lending, and corporate diversification.

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Paper provided by EconWPA in its series Game Theory and Information with number 0403003.

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Length: 45 pages
Date of creation: 22 Mar 2004
Handle: RePEc:wpa:wuwpga:0403003
Note: Type of Document - pdf; pages: 45. 45 pages, pdf document.
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