The B.E. Journal of Macroeconomics, Contributions – 10.1 (2010), article 22
Keywords: Private equity, learning, portfolio choice, occupational choice, life-cycle
Abstract: Entrepreneurs invest a large share of their financial wealth in a single business that they personally manage. Despite the large risk implied by this undiversified investment they do not seem to require any extra return on a diversified public equity index. In light of the large public equity premium this fact poses a new asset pricing puzzle. In the present paper I use a quantitative model to explore the issue and find that the choice to become entrepreneur can be rationalized even with a negative private equity premium when the full return on entrepreneurial investment is properly accounted for. The key assumption is that the quality of a business project is not precisely known upon entry and is learned over time. As long as it is possible to switch back to paid-employment, it is worth experimenting with entrepreneurship to find out if the project is good even if initially the expected return is low.