Entrepreneurial Under-Diversification: Over Optimism and Overconfidence

Abstract

Our model wants to explain how overconfidence and over optimism lead entrepreneurs to overinvest in their companies, underestimating risks and overestimating expected returns. The entrepreneur has to choose which part of her wealth to invest in her private company and which one in the stock market. Overconfidence and over optimism are parameters in our model, and they bias the entrepreneur’s portfolio allocation. With a simulation analysis, we calculate overconfidence and over optimism levels implicit in the entrepreneurs' observable portfolio, instead of using proxies or indirect measures. Our explicit measure of entrepreneurial under-diversification could be used in empirical analyses.

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