Resuscitating businessman risk: A rationale for familiarity-based portfolios

Abstract

This paper studies two frequently observed portfolio behaviors that are seemingly inconsistent with rational portfolio choice. The first is the tendency of workers and entrepreneurs to hold their companyʼs stock. The second is the propensity of workers to limit their equity holdings through time. The explanation offered here for both of these behaviors lies in the option to switch jobs when oneʼs company does poorly. This is equivalent to holding put options on oneʼs own company stock and call options on the other companyʼs stock, where both options must be exercised at the same time. Given these initial undiversified implicit financial holdings, workers need to allocate a relatively large share of their regular financial assets to their own companyʼs stock and a relatively small share to the stock of their alternative employment simply to restore overall portfolio balance. Although this effect can only create some hedging demand for companyʼs stock, it is a factor of potentially major import for assessing the suitability of workersʼ financial decisions. I find that, under certain conditions, workers optimally hold almost 40% of their financial wealth in their companyʼs stock.