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Mean Reversion and Consumption Smoothing

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  • Black, Fischer

Abstract

Most models of the evolution of wealth and consumption assume that wealth volatility and risk premium are constant. But in fact, volatility declines, and risk premium seems to decline, as wealth rises. A model that allows mean reversion in the sense that the risk premium declines as wealth rises can help explain both the "consumption smoothing puzzle" and the "equity premium puzzle." In an example of such a model that gives us an analytic solution, direct and derived risk aversion are both constant, but differ. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

Suggested Citation

  • Black, Fischer, 1990. "Mean Reversion and Consumption Smoothing," The Review of Financial Studies, Society for Financial Studies, vol. 3(1), pages 107-114.
    • Handle: RePEc:oup:rfinst:v:3:y:1990:i:1:p:107-14
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    Citations

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    Cited by:

    1. Bruhn, Kenneth & Steffensen, Mogens, 2013. "Optimal smooth consumption and annuity design," Journal of Banking & Finance, Elsevier, vol. 37(8), pages 2693-2701.
    2. Campbell, John Y, 1996. "Understanding Risk and Return," Journal of Political Economy, University of Chicago Press, vol. 104(2), pages 298-345, April.
    3. Fuerst, Michael E., 2006. "Investor risk premia and real macroeconomic fluctuations," Journal of Macroeconomics, Elsevier, vol. 28(3), pages 540-563, September.
    4. Liya Liu & Yingjie Niu & Yuanping Wang & Jinqiang Yang, 2020. "Optimal consumption with time-inconsistent preferences," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 70(3), pages 785-815, October.
    5. Carbajal-De-Nova, Carolina & Venegas-Martínez, Francisco, 2019. "On the paradigm shift of asset pricing models, before and after the global financial crisis: a literature review," Panorama Económico, Escuela Superior de Economía, Instituto Politécnico Nacional, vol. 15(29), pages 7-38, Primer se.
    6. Kandel, Shmuel & Stambaugh, Robert F, 1996. "On the Predictability of Stock Returns: An Asset-Allocation Perspective," Journal of Finance, American Finance Association, vol. 51(2), pages 385-424, June.
    7. Douch, Mohamed, 2004. "Equity Premiums In Small Open Economy," MPRA Paper 14613, University Library of Munich, Germany.
    8. Hardouvelis, Gikas A. & Kim, Dongcheol & Wizman, Thierry A., 1996. "Asset pricing models with and without consumption data: An empirical evaluation," Journal of Empirical Finance, Elsevier, vol. 3(3), pages 267-301, September.
    9. Meyer, Donald J. & Meyer, Jack, 2005. "Risk preferences in multi-period consumption models, the equity premium puzzle, and habit formation utility," Journal of Monetary Economics, Elsevier, vol. 52(8), pages 1497-1515, November.
    10. Basak, Suleyman, 1999. "On the fluctuations in consumption and market returns in the presence of labor and human capital: An equilibrium analysis," Journal of Economic Dynamics and Control, Elsevier, vol. 23(7), pages 1029-1064, June.
    11. Campbell, John Y, 1993. "Intertemporal Asset Pricing without Consumption Data," American Economic Review, American Economic Association, vol. 83(3), pages 487-512, June.
    12. Jean-Pierre Zigrand & Hyun Song Shin & Jon Danielsson, 2010. "Risk Appetite and Endogenous Risk," FMG Discussion Papers dp647, Financial Markets Group.
    13. Kandel, Shmuel & Stambaugh, Robert F., 1991. "Asset returns and intertemporal preferences," Journal of Monetary Economics, Elsevier, vol. 27(1), pages 39-71, February.
    14. Fang Zhou & Liutang Gong & Yaping Wang, 2008. "Mean Reversion and Consumption Smoothing: A Comment," Annals of Economics and Finance, Society for AEF, vol. 9(2), pages 397-399, November.
    15. Yuanping Wang & Yingjie Niu & Siwen Gong, 2022. "Robust consumption policy with the desire for wealth accumulation," Review of Economics of the Household, Springer, vol. 20(3), pages 993-1025, September.
    16. Balvers, Ronald J. & Huang, Dayong, 2007. "Productivity-based asset pricing: Theory and evidence," Journal of Financial Economics, Elsevier, vol. 86(2), pages 405-445, November.
    17. Liutang Gong & Yulei Luo & Heng-fu Zou, 2009. "Social Status, the Spirit of Capitalism, and the Term Structure of Interest Rates in Stochastic Production Economies," CEMA Working Papers 372, China Economics and Management Academy, Central University of Finance and Economics.
    18. Ogden, Joseph P., 2003. "The calendar structure of risk and expected returns on stocks and bonds," Journal of Financial Economics, Elsevier, vol. 70(1), pages 29-67, October.
    19. Eric Hillebrand, 2005. "Mean Reversion Expectations and the 1987 Stock Market Crash: An Empirical Investigation," Finance 0501015, University Library of Munich, Germany.

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