Habit Formation and the Equity-Premium Puzzle: a Skeptical View

We argue that ceteris paribus, introducing a habit that resolves the equity premium puzzle is equivalent to increasing the coefficient of relative risk aversion. Thus, if habit is modeled subject to the constraint that the Arrow-Pratt coefficient of relative risk aversion is held at a constant ‘acceptable’ level, the effect on the equity premium is not quantitatively significant. In a dynamic setting, the fluctuations of the habit increase the equity premium, slightly. However, modest improvement in the model’s predictive power comes at a cost of generating unrealistic fluctuations in the risk-free interest rate. Our analysis of these findings yields the following result: a habit is observationally equivalent,up to afirst order approximation, to a higher relative risk aversion and to a preference shock. Both these effects are known to be insufficient for resolving the equity-premium puzzle.