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Unformatted text preview: Electronic copy available at: http://ssrn.com/abstract=1142122 Diversification and its Discontents: Idiosyncratic and Entrepreneurial Risk in the Quest for Social Status. * Journal of Finance, forthcoming Nikolai Roussanov † The Wharton School, University of Pennsylvania December 11, 2009 Abstract Social status concerns effect investors’ decisions by driving a wedge in atti- tudes towards aggregate and idiosyncratic risks. I model such concerns by em- phasizing the desire to “get ahead of the Joneses,” which implies that aversion to idiosyncratic risk is lower than 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 pri- vate equity, and experience greater volatility of wealth and consumption growth, consistently with empirical evidence. * I am grateful to John Cochrane, John Heaton, Tobias Moskowitz, and Pietro Veronesi for their advice and encouragement. I also benefited from comments and suggestions by Andrew Abel, Fernando Alvarez, George-Marios Angeletos, Nicholas Barberis, Frederico Belo, Hui Chen, Raj Chetty, George Constantinides, Darrell Duffie, Raife Giovinazzo, William Goetzmann, Jo˜ao Gomes, Luigi Guiso, Lars Hansen, Campbell Harvey (the editor), Erik Hurst, Urban Jermann, Timothy Johnson, Kenneth Judd, Ron Kaniel, Leonid Kogan, David Laibson, Marlena Lee, Deborah Lucas, Hanno Lustig, Gregor Matvos, Stavros Panageas, ˇ Luboˇ s P´astor, Monika Piazzesi, ˆLukasz Pomorski, Andrew Postlewaite, Jesse Shapiro, Annette Vissing-Jørgensen, Jessica Wachter, Amir Yaron, Motohiro Yogo and Stephen Zeldes, as well as the anonymous referee and associate editor, and seminar participants at a number of institutions and conferences. This research was partially supported by the Ewing Marion Kauffman Foundation and by the National Center for Supercomputing Applications, as well as the Sanford Grossman Fellowship in honor of Arnold Zellner. † Contact: [email protected] 1 Electronic copy available at: http://ssrn.com/abstract=1142122 Diversification and risk-sharing are fundamental principles of modern finance and macroeconomics. However, empirical evidence suggests that household portfolios are poorly diversified, with many people reporting substantial holdings of a single stock. For the wealthiest households large shares in closely held businesses constitute a particularly important source of risk (e.g. Heaton and Lucas (2000a)). It is not surprising that entrepreneurs bear substantial undiversified risk, since it is important for mitigating moral hazard and/or adverse selection problems. Yet, from a standpoint of portfolio theory, entrepreneurship does not appear to be well compensated, implying that many investors are willing to take poorly rewarded risks despite the availability of superior...
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- Fall '09
- Utility, joneses, relative wealth, aggregate wealth