The Equity Premium and the One Percent

Abstract

We show that in a general equilibrium model with heterogeneity in risk aversion or belief, shifting wealth from an agent who holds comparatively fewer stocks to one who holds more reduces the equity premium. Since empirically the rich hold more stocks than do the poor, inequality should predict subsequent excess stock market returns. Consistent with our theory, we find that when the income share of top earners in the U.S. rises, subsequent one year excess market returns significantly decline. This negative relation is robust to (i) controlling for classic return predictors such as the price-dividend and consumption-wealth ratios, (ii) predicting out-of-sample, and (iii) instrumenting with changes in estate tax rates. Cross-country panel regressions suggest that the inverse relation between domestic inequality and returns also holds outside of the U.S., with stronger results in relatively closed economies than in ones with low home bias (in which U.S. inequality predicts returns).

Keywords: equity premium, heterogeneous risk aversion, return prediction, wealth distribution, international equity markets

JEL Classification: D31, D52, D53, F30, G12, G17