Abstract

We show that when investment increases the probability of success of a project, diversifying a fixed budget across more uncorrelated projects increases overall portfolio risk. This result holds for portfolios comprised of projects with binary outcomes—success or failure—where the payoffs associated with each outcome are exogenous (and can be replaced by an entire exogenous payoff distribution). Based on this finding, we hypothesize that risk-averse managers in Venture Capital (VC) limit portfolio diversification to mitigate risk. We propose a testable prediction, based on the correlation between a VC portfolio’s diversification and its subsequent returns, that distinguishes our hypothesis from the general premise that diversification reduces risk. Existing empirical evidence from the VC industry, showing a positive correlation between diversification and returns, is consistent with our hypothesis.