'Big Bang' in Micro Consumption and Its Implications for Asset Pricing

Abstract

We establish some facts about micro consumption that open an avenue toward fully solving various consumption-based asset pricing puzzles. We find that top quantiles of consumption growth of the majority people are positively correlated with asset returns; at low quantiles the correlations for many people are negative. This partial negative correlation accounts for the low time-series correlation between asset returns and the growth rates of aggregated consumption, which is at the heart of many pricing anomalies. Our findings suggest that a large proportion of individuals’ preference toward consumption is risk-seeking at low consumption-growth states, while most individuals are risk-averse at high consumption-growth states. Both risk-seeking and risk-averse individuals demand a positive equity premium at their respective states. The equity premium puzzle arises from modeling risk-seeking behaviors as risk aversion, which partially generates a negative equity premium.