Internal vs. External Habit Formation: The Relative Importance for Asset Pricing
33 Pages Posted: 5 Mar 2007 Last revised: 24 Sep 2011
Date Written: January 7, 2010
I present a generalized model that structurally nests both "catching up with the Joneses" (external habit) and "time non-separable" (internal habit) preference specifications. The model's asset pricing implications are confronted with the observed aggregate US consumption and asset returns data to determine the relative importance of "catching up with the Joneses" and internal habit formation. I show that long-horizon aggregate returns are more consistent with long-run habit as opposed to "catching up with the Joneses" preferences. This result supports the findings of Parker and Julliard (2005) that the ultimate consumption risk explains more of the cross-sectional variation in stock returns.
Keywords: Asset pricing, consumption-based asset pricing models, time non-separabilities, external habit, internal habit, long horizon returns
JEL Classification: E21, E44, G12
Suggested Citation: Suggested Citation