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Underdiversification in Private Companies: Required Returns and Incentive Effects

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  • Müller, Elisabeth

Abstract

Owners of private companies are often highly underdiversified which exposes them to idiosyncratic risk. We investigate the consequences of underdiversification at the company level. Information on US companies and their owners is obtained from the Survey of Consumer Finances and the Survey of Small Business Finances. Underdiversification, measured as the share of the owner's net worth invested in the company, has a significant positive relationship with profitability, measured as the return on equity. We identify two causes for this underdiversification effect: higher required returns and higher effort. The results have important consequences for investment decisions at private companies.

Suggested Citation

  • Müller, Elisabeth, 2004. "Underdiversification in Private Companies: Required Returns and Incentive Effects," ZEW Discussion Papers 04-29, ZEW - Zentrum für Europäische Wirtschaftsforschung / Center for European Economic Research.
  • Handle: RePEc:zbw:zewdip:2183
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    Cited by:

    1. Mueller, Elisabeth, 2008. "How does owners' exposure to idiosyncratic risk influence the capital structure of private companies?," Journal of Empirical Finance, Elsevier, vol. 15(2), pages 185-198, March.

    More about this item

    Keywords

    underdiversification; required returns; incentives; private companies; wealth; entrepreneurship;

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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