Learning Versus Diversification in Project Choice

43 Pages Posted: 20 Mar 2004

See all articles by Nidhiya Menon

Nidhiya Menon

Brandeis University - International Business School

Narayanan Subramanian

Cornerstone Research - Boston Office

Date Written: May 10, 2004

Abstract

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 relative levels of the different kinds of risk and (iii) his risk-aversion and investment horizon. We show that, contrary to intuition, an increase in the prior uncertainty regarding the technology may lead to a decrease in diversification. Our theory is applicable to occupational choice within households, project choice under group lending, and corporate diversification.

Keywords: Bayesian learning, insurance, risk-sharing

JEL Classification: D81, D83

Suggested Citation

Menon, Nidhiya and Subramanian, Narayanan, Learning Versus Diversification in Project Choice (May 10, 2004). Available at SSRN: https://ssrn.com/abstract=518066 or http://dx.doi.org/10.2139/ssrn.518066

Nidhiya Menon

Brandeis University - International Business School ( email )

Mailstop 32
Waltham, MA 02454-9110
United States
781-736-2230 (Phone)
781-736-2269 (Fax)

Narayanan Subramanian (Contact Author)

Cornerstone Research - Boston Office ( email )

699 Boylston Street
Boston, MA 02115
United States
(617) 927-3000 (Phone)
(617) 927-3100 (Fax)

HOME PAGE: http://www.cornerstone.com/

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