Explaining the Poor Performance of Consumption-Based Asset Pricing Models

Working Paper: NBER ID: w7237

Authors: John Y. Campbell; John H. Cochrane

Abstract: The poor performance of consumption-based asset pricing models relative to traditional portfolio-based asset pricing models is one of the great disappointments of the empirical asset pricing literature. We show that the external habit-formation model economy of Campbell and Cochrane (1999) can explain this puzzle. Though artificial data from that economy conform to a consumption-based model by construction, the CAPM and its extensions are much better approximate models than is the standard power utility specification of the consumption-based model. Conditioning information is the central reason for this result. The model economy has one shock, so when returns are measured at sufficiently high frequency the consumption-based model and the CAPM are equivalent and perfect conditional asset pricing models. However, the model economy also produces time-varying expected returns, tracked by the dividend-price ratio. Portfolio-based models capture some of this variation in state variables, which a state-independent function of consumption cannot capture, and so portfolio-based models are better approximate unconditional asset pricing models.

Keywords: No keywords provided

JEL Codes: G00

Causal Claims

Cause	Effect
Shock in the model economy (E19)	Equivalence of consumption-based models and CAPM at high frequencies (C58)
Portfolio-based models (G11)	Capture time-varying expected returns (C22)
Conditioning information (D80)	Equivalence of consumption-based models and CAPM at high frequencies (C58)
Dividend-price ratio (G35)	Track time-varying expected returns (C22)
Consumption-based models (D12)	Poor performance compared to CAPM (G19)
Model economy with single shock (E19)	Equivalence of consumption-based models and CAPM (D11)
Consumption-based models (D12)	Cannot account for variation in state variables (C32)