A real options perspective on R&D portfolio diversification

Sjoerd van Bekkum; Enrico Pennings; Han Smit

This paper shows that the presence of conditional staging in R&D (Research & Development) has a critical impact on portfolio risk, and changes diversification arguments when a portfolio is constructed. When R&D projects exhibit option-like characteristics, correlation between projects plays a more complicated role than traditional portfolio diversification would suggest. Real option theory argues that research projects with conditional phases have option-like risk and return properties, and are different from unconditional projects. We show that although the risk of a portfolio always depends on the correlation between projects, a portfolio of conditional R&D projects with real option characteristics has fundamentally different risk than a portfolio of unconditional projects. When conditional R&D projects are negatively correlated, portfolio risk is hardly reduced by diversification. When projects are positively correlated, however, diversification is more effective than these tools predict.

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Year of publication:	2008
Authors:	Bekkum, Sjoerd van ; Pennings, Enrico ; Smit, Han T. J.
Publisher:	Rotterdam [u.a.] : Tinbergen Inst.
Subject:	Real Options \| Research & Development (R&D) \| Risk Management \| Monte Carlo Simulation \| Realoptionsansatz \| Real options analysis \| Monte-Carlo-Simulation \| Monte Carlo simulation \| Theorie \| Theory \| Risikomanagement \| Risk management \| Portfolio-Management \| Portfolio selection \| Innovationsmanagement \| Innovation management \| Simulation