The Consumption Risk of the Stock Market
- Comments and Discussion
N. Gregory Mankiw:
About twenty years ago, the consumption-based capital asset pricing model took center stage in discussions of asset pricing and economic fluctuations. Since then many economists have puzzled about the economy's most important risk premium, the spread between the equity return and the risk-free return. According to the model, the right measure of risk is consumption risk, but the measured consumption risk associated with the stock market seems too small to explain an equity premium of 6 percentage points, unless consumers are extraordinarily risk averse.
Fortunately, we have made progress toward explaining the equity premium, and this paper by Jonathan Parker makes a significant contribution to that effort. The resolution to the puzzle rests, at least in part, on two facts that several studies have now documented.
The first fact is that the risk of equities measured using consumption by stockholders alone is greater than the risk measured using aggregate consumption. Stephen Zeldes and I first documented this using data on food consumption from the Michigan Panel Study of Income Dynamics.1 This finding has been confirmed in other, arguably better data sets by Annette Vissing-Jørgensen and by Parker in this paper.2
Of course, this fact does not explain why so many people do not hold stock, and this can be viewed as a puzzle in its own right. Part of the answer is that many people live hand to mouth and own hardly any assets [End Page 334] at all. But that is not the whole story. Zeldes and I documented that many people with sizable liquid assets hold no stock. The most plausible answer for these people is information costs: many people just do not understand stocks and bonds and do not feel comfortable buying them. Imagine how the typical economist would feel if advised to invest his or her retirement funds in rare stamps or seventeenth-century artwork. Most of us probably know nothing about these markets, but we know to stay away from things we do not understand.
The second fact that helps explain the equity premium is that consumption risk is higher when measured using medium-term changes in consumption than when using only the contemporaneous co-movement of consumption with stock market returns. This fact is documented both here and in a parallel paper by Xavier Gabaix and David Laibson.3 Parker estimates (in the first column of his table 1) that lengthening the time horizon raises the measured consumption risk of equities by a factor of ten.
With the benefit of hindsight, it seems that both of these facts should have been obvious. Regarding the fact of limited stock market participation, it is hardly a shock that many people do not hold equities and that those who do hold them face more equity risk than those who do not. Regarding the time horizon, the stock market is widely viewed as a leading indicator of economic activity, two-thirds of which is consumer spending. Thus, it is no surprise that increasing the time horizon raises the measured covariance.
The literature on consumption-based asset pricing neglected this observation until recently because, according to standard theory as set forth in Robert Hall's seminal 1978 paper, consumption should follow a random walk.4 In particular, the stock market should not be correlated with future consumption changes, so the contemporaneous risk and the medium-term risk (as measured in Parker's table 1) should be the same. Yet this theoretical prediction has never been fully confirmed by the data. In that same 1978 paper, Hall tested the theory and found that the random-walk hypothesis worked well, with a single exception: the stock market predicted future consumption growth. He hypothesized that some part of consumption takes time to respond to changes in wealth. This conjecture [End Page 335] foreshadowed by two decades this paper by Parker and the parallel one by Gabaix and Laibson.
Although Hall initially proposed this delayed-adjustment hypothesis, he never took it very seriously, and for good reason. If you add adjustment costs to the standard permanent income model, you are likely to get strong...
