March 2021

Consumption-Based Asset Pricing When Consumers Make Mistakes

Chris Anderson

Abstract:

I analyze the implications of allowing consumers to make mistakes on the risk-return relationships predicted by consumption-based asset pricing models. I allow for consumption mistakes using a model in which a portfolio manager selects investments on a consumer's behalf. The consumer has an arbitrary consumption policy that could reflect a wide range of mistakes. For power utility, expected returns do not generally depend on exposure to single-period consumption shocks, but robustly depend on exposure to both long-run consumption and expected return shocks. I empirically show that separately accounting for both types of shocks helps explain the equity premium and cross section of stock returns.

DOI: https://doi.org/10.17016/FEDS.2021.015

PDF: Full Paper

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Last Update: March 19, 2021