Diversification and its Discontents: Idiosyncratic and Entrepreneurial Risk in the Quest for Social Status

Abstract

Social status concerns effect investors' decisions by driving a wedge in attitudes towards aggregate and idiosyncratic risks. I model such concerns by emphasizing the desire to "get ahead of the Joneses," which implies that investors' aversion to idiosyncratic risk is lower than their aversion to aggregate risk. The model predicts that investors hold concentrated portfolios in equilibrium, which helps rationalize the puzzlingly small premium for undiversified entrepreneurial risk. In the model, status concerns are more important for the wealthier households. Consequently, these households own a disproportionate share of risky assets, particularly private equity, and experience greater volatility of wealth and consumption growth, consistently with empirical evidence.

Keywords: portfolio choice, diversification, social status, wealth distribution

JEL Classification: E21, G11, D14, D31, L26