Erasmus Research Institute of Management (ERIM), Erasmus University Rotterdam (ERIM is the joint researchinstitute of the Rotterdam School of Management, Erasmus University and the Erasmus School of Economics (ESE) at Erasmus University Rotterdam)
This paper shows that the conditionality of investment decisions in R&D has a critical impact on portfolio risk, and implies that traditional diversification strategies should be reevaluated when a portfolio is constructed. Real option theory argues that research projects have conditional or option-like risk and return properties, and are different from unconditional projects. 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 a fundamentally different risk than a portfolio of unconditional projects. When conditional R&D projects are negatively correlated, diversification only slightly reduces portfolio risk. When projects are positively correlated, however, diversification proves more effective than conventional tools predict.