Non‐addictive Habit Formation and the Equity Premium Puzzle

Milind M. Shrikhande

European Financial Management, 1997, vol. 3, issue 3, 293-319

Abstract: I analyse a model in a simple representative‐agent economy with one risky and one riskless asset, populated by habit forming consumer‐investors. These consumer‐investors exhibit non‐addictive habit formation in the sense that the current consumption rate of the consumer‐investors can fall below their past habit‐forming consumption rate. I endogenise the real riskless rate of return in this representative‐agent economy and find that the equity premium puzzle is resolved for plausible values of the coefficient of relative risk aversion, the discount rate, and the intensity of non‐addictive habit formation. These values have been validated in previous empirical or survey‐based studies. Non‐addictive habit‐formation studied here complements and extends current research on habit‐forming preferences. Given a constant investment opportunity set, the real riskless rate in the economy increases with relative risk aversion of the consumer and decreases as the habit‐formation intensity increases. Extensions with time‐varying investment opportunity sets could explain the low risk‐free rate and the relatively large variability of the market return over the variability of the risk‐free rate through time.

Date: 1997
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