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Entrepreneurs often invest a large share of their personal wealth in their firms, exposing themselves to idiosyncratic risk. We propose a theoretical model showing how overconfidence and overoptimism may help to explain this evidence. We focus on overprecision, but we also consider overestimation and overplacement. Numerical examples show a more substantial role for overconfidence than overoptimism in determining entrepreneurs' portfolio allocations. We test the effect of the two latent variables—overconfidence and overoptimism—on small business owners' portfolio allocations. We use a unique dataset including private information on Italian small and medium enterprises and a structural equation modeling approach. A positive relationship between overconfidence and entrepreneurs' investments in their own companies is confirmed.

We propose a theoretical …