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.

Additional Metadata
Keywords Monte Carlo simulation, real options, research and development (R&D), risk management
Publisher Tinbergen Institute
Persistent URL hdl.handle.net/1765/10897
Citation
van Bekkum, S, Pennings, H.P.G, & Smit, J.T.J. (2008). A Real Options Perspective on R&D Portfolio Diversification (No. TI 2008-003/2). Discussion paper / Tinbergen Institute. Tinbergen Institute. Retrieved from http://hdl.handle.net/1765/10897