Learning Versus Diversification in Project Choice
43 Pages Posted: 20 Mar 2004
Date Written: May 10, 2004
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: Suggested Citation
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By Keldon Bauer