of this section, but is shared by all consumption-based models with con-
stant discount rates.^27
The unrealistically low stock return volatility generated by the model also
hampers its ability to explain the equity premium: the average stock returns
in table 7.13 are considerably lower than the empirical value. Intuitively,
even though our investor is loss averse, the stock market fluctuations are not
large enough to scare him into demanding a high equity premium as com-
pensation. More generally, our results show that loss aversion can be help-
ful in understanding the equity premium, but only in conjunction with a
mechanism that makes stock returns more volatile than underlying cash
flows. In our model, this mechanism is a changing degree of loss aversion,
but it could also be based on changing perceptions of risk, or excessive ex-
trapolation of cash flows into the future.
7 .ConclusionIn this chapter we study asset prices in an economy where investors derive di-
rect utility not only from consumption but also from fluctuations in the value
of their financial wealth. They are loss averse over these fluctuations and how
loss averse they are, depends on their prior investment performance.
Our main finding is that in such an economy, asset prices exhibit phenom-
ena very similar to what has been observed in historical data. In particular,
stock returns have a high mean, are excessively volatile, and are significantly
predictable in the time series. They are also only weakly correlated with con-
sumption growth.
The analysis in this chapter raises a number of questions for further inves-
tigation. For the sake of simplicity, we have studied an economy containing
264 BARBERIS, HUANG, SANTOS
Table 7.13
Asset Returns When Prior Outcomes Have No EffectEmpirical
b 0 = 0 b 0 =0.7 b 0 = 2 b 0 = 100 ValueLog risk-free rate 3.79 3.79 3.79 3.79 0.58
Log excess stock return
Mean −0.65 1.30 2.17 2.88 6.03
Standard deviation 12.0 12.0 12.0 12.0 20.02
Sharpe ratio −0.05 0.11 0.18 0.24 0.3
Moments of asset returns are expressed as annual percentages. Empirical values are based
on Treasury Bill and NYSE data from 1926–1995. The parameter b 0 controls how much the
investor cares about financial wealth fluctuations.
(^27) This category includes papers that use first-order risk-aversion, such as Epstein and Zin
(1990). See Campbell (2000) for a discussion of this issue.