Optimal Portfolio Diversification and Product-Market Interactions

Although most shareholders hold diversified portfolios, the corporate finance literature postulates that shareholders maximise firm value, while managers sometimes do not. We argue to the contrary that undiversified managers may care more about firm-level risk and return than about the value of their shareholders'diversified portfolio. These two objectives may differ in presence of product-market interactions. We derive a financial and product market equilibrium in presence of a large, diversified investor and a large number of small shareholders. Stock prices, asset allocation and product-market competition all depend on investors'risk-aversion, initial endowment, and industry characteristics. We discuss implications to institutional investor activism, executive compensation contracts, venture capital, and the decision to go public.