From Which Consumption-Based Asset Pricing Models Can Investors Profit? Evidence from Model-Based Priors

Abstract

This paper analyzes whether consumption-based asset pricing models improve the equity premium forecasts of a hypothetical investor with access to these models from 1947 onwards. The investor imposes economic constraints derived from asset pricing models as model-based priors on predictive regression parameters through a Bayesian framework. Three models are considered: Habit Formation, Long-Run Risk, and Prospect Theory. The model-based priors generally perform better than priors that shrink the parameter estimates to the historical average model and priors that impose a positive equity premium. This analysis helps to assess the value of consumption-based asset pricing models to investors.

Keywords: Return predictability, consumption-based asset pricing, Bayesian econometrics

JEL Classification: G11, G12, G17