Optimal Diversification: Reconciling Theory and Evidence


  • Joao Gomes,

  • Dmitry Livdan

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    • The Wharton School, University of Pennsylvania and Bauer College of Business, University of Houston. We are grateful to Andrew Abel, Michael Brandt, Domenico Cuoco, Jan Eberly, Simon Gervais, Armando Gomes, Francisco Gomes, Gary Gorton, John Graham, Skander van den Heuvel, Rich Kihlstrom, Leonid Kogan, Jan Mahrt-Smith, Vojislav Maksimovic, Andrew Metrick, Gordon Phillips, Tom Sargent, Jeremy Stein, and an anonymous referee, as well as to seminar participants at Kellogg, Wharton, Penn State, the 2002 SED and Econometric Society Meetings, and the 2003 AFA meetings. Financial support from the Rodney L. White Center for Financial Research is gratefully acknowledged. This paper combines our earlier papers “Optimal Diversification” and “The Performance of Optimally Diversified Firms: Reconciling Theory and Evidence.”


In this paper we show that the main empirical findings about firm diversification and performance are consistent with the maximization of shareholder value. In our model, diversification allows a firm to explore better productive opportunities while taking advantage of synergies. By explicitly linking the diversification strategies of the firm to differences in size and productivity, our model provides a natural laboratory to investigate several aspects of the relationship between diversification and performance. Specifically, we show that our model can rationalize the evidence on the diversification discount (Lang and Stulz (1994)) and the documented relation between diversification and productivity (Schoar (2002)).