Consumption-Based Asset Pricing When Consumers Make Mistakes

Abstract

I analyze the implications of allowing consumers to make mistakes on the risk-return relationships predicted by consumption-based asset pricing models. I allow for consumption mistakes using a model in which a portfolio manager selects a portfolio on a consumer's behalf. The consumer has an arbitrary consumption policy which could reflect a wide range of mistakes. In the case of power utility, expected returns may no longer depend on exposure to single-period consumption shocks, but will robustly depend on exposure to long-run consumption and expected return shocks. My results generalize and I show that expected return shocks are empirically important.

Keywords: Asset pricing, consumption-based asset pricing, consumption mistakes, long-run risk

JEL Classification: G11, G12, G40