By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior

Source: Campbell, J. Y. & Cochrane, J. H. (1999) · Journal of Political Economy 107(2), 205–251 · DOI: 10.1086/250059

The question

Standard consumption-based (power-utility) asset pricing cannot match the high equity premium, the

volatility and long-horizon predictability of excess returns, or the countercyclical variation of

stock-market volatility — all while keeping the risk-free rate smooth and consumption growth nearly

i.i.d. Can a single, disciplined modification of preferences reproduce these facts?

Driving process: consumption growth is i.i.d. (constant conditional mean and variance) — the

model adds no exogenous time-varying risk to consumption.

Preferences add a slow-moving external habit X to power utility, so utility depends on the

surplus consumption ratio S = (C − X)/C. S = 0 is the extreme bad state.

Local relative risk aversion equals γ/S, so **risk aversion rises as consumption falls toward

habit** in business-cycle troughs, and falls in booms — generating cyclical variation in the price

of risk from smooth consumption.

Log surplus consumption s evolves as a heteroskedastic AR(1); the sensitivity function λ(s) is

chosen so that (i) the real risk-free rate is constant (or nearly so) and (ii) habit moves with

consumption but stays below it.

A high and time-varying equity premium with countercyclical expected excess returns and

Sharpe ratios.

Procyclical price–dividend ratios and long-horizon return predictability.

Countercyclical, time-varying stock-market volatility and excess volatility relative to dividends.

It reproduces the standard power-utility model's empirical failures (Euler-equation rejections,

high implied risk aversion, low consumption-growth/interest-rate correlation) — and, unlike many

habit models, does not require a volatile risk-free rate or a skewed/negative marginal rate of

substitution.

A benchmark "rational" model of time-varying risk premia, calibrated to match U.S. aggregate moments

and able to track much of the history of stock prices given only consumption data. It is the standard

external-habit counterpart to behavioral predictability stories and to long-run-risk (Bansal–Yaron)

and rare-disaster models.

The habit/sensitivity specification is engineered to hit target moments; its micro-foundations and

the implied very high state-dependent risk aversion are debated.

A representative-agent, aggregate model — it does not speak to the cross-section of returns directly.

Campbell, J. & Cochrane, J. (1999) — By Force of Habit — Journal of Political Economy

Mehra, R. & Prescott, E. (1985) — The Equity Premium: A Puzzle — Journal of Monetary Economics

Bansal, R. & Yaron, A. (2004) — Risks for the Long Run — Journal of Finance

Provenance: verified/generated from the paper's full text.