Asset Pricing with Fading Memory

Building on recent evidence that lifetime experiences shape individuals’ macroeconomic expectations, we study asset prices in an economy in which a representative agent learns with fading memory from experienced endowment growth. The agent updates subjective beliefs with constant gain, which in- duces memory loss, but is otherwise Bayesian in evaluating uncertainty. The model produces perpetual learning, substantial priced long-run growth rate uncertainty, and, conveniently, a stationary economy. This approach resolves many asset pricing puzzles and it reconciles model-implied subjective belief dynamics with survey data on individual investor return expectations within a simple setting with IID endowment growth, constant risk aversion, and a gain parameter calibrated to microdata estimates. The objective equity premium is high and strongly counter-cyclical in the sense of being negatively related to experienced stock market payout growth (a long-run weighted average of past growth rates). In contrast, the subjective equity premium is slightly pro-cyclical. As a consequence, subjective expectations errors are predictable and negatively related to past experienced payout growth. Consistent with this theory, we show empirically that experienced payout growth is negatively related to future stock market excess returns. Based on expectations data from individual investor surveys spanning several decades, we show that this measure of experienced growth is also strongly negatively related to subjective expectations errors.