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The Wealth-Consumption Ratio: A Litmus Test for Consumption-Based Asset Pricing Models

  • Stijn Van Nieuwerburgh


  • Hanno Lustig


The volatility of the price-dividend ratio on stocks, the predictability of stock returns, and the lack of predictability in dividend growth are commonly interpreted as evidence of substantial time-variation in risk premia. We construct the wealth-consumption ratio for the U.S., the price-dividend ratio on total wealth. We show that it is at least five times less volatile than the price-dividend ratio on stocks. The wealth-consumption ratio encodes information about conditional market prices of risk, and hence about asset prices. Matching its properties is a litmus test for consumption-based asset pricing models. Models that match the predictability of equity returns impute too much predictability to total wealth returns and hence too much volatility to the wealth-consumption ratio, because they rely on time variation in the risk premium on total wealth. The smoothness of the wealth-consumption ratio suggests that there may be less time-variation in market prices of risk than commonly inferred from equity prices alone.

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Paper provided by Society for Economic Dynamics in its series 2007 Meeting Papers with number 398.

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Date of creation: 2007
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Handle: RePEc:red:sed007:398
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Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA

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