Lazy Investors, Discretionary Consumption, and the Cross-Section of Stock Returns

When consumption betas of stocks are computed using year-over-year consumption growth based upon the fourth quarter, the consumption-based asset pricing model (CCAPM) explains the cross-section of stock returns as well as the Fama and French (1993) three-factor model. The CCAPM's performance deteriorates substantially when consumption growth is measured based upon other quarters. For the CCAPM to hold at any given point in time, investors must make their consumption and investment decisions simultaneously at that point in time. We suspect that this is more likely to happen during the fourth quarter, given investors' tax year ends in December. THERE IS GENERAL AGREEMENT IN THE LITERATURE that the risk premium that investors require to invest in stocks varies across stocks of different types of firms in a systematic way. In particular, investors appear to be content to receive a lower return on average to invest in growth firms compared to value firms, and require a higher return to invest in smaller firms compared to larger firms. The question is, why? According to the standard consumption-based asset pricing model (CCAPM) developed by Rubinstein (1976), Lucas (1978), and Breeden (1979), investors will be content to accept a lower return on those assets that provide better insurance against consumption risk by paying more when macroeconomic events unfavorably affect consumption choices. In particular, according to the CCAPM, to a first order the risk premium on an asset is a scale multiple of its exposure to consumption risk, the covariance of the return on the asset with contemporaneous aggregate consumption growth. Hence, to the extent that the CCAPM holds, we should find that growth firms engage in activities that have less exposure to consumption risk compared to those of value firms, and similarly, smaller firms are exposed to higher consumption *Jagannathan is at the Kellogg School of Management, Northwestern University and the National Bureau of Economic Research; Wang is at the School of Accounting and Finance, Hong Kong Polytechnic University. We thank Douglas Breeden, John Cochrane, Zhi Da, Kent Daniel, Lars Hansen, John Heaton, Charlie Himmelberg, Martin Lettau, Deborah Lucas, Sydney Ludvigson, Monika Piazzesi, Ernst Schaumburg, Michael Sher, Annette Vissing-Jorgensen, Zhenyu Wang, Robert Stambaugh (editor), an anonymous referee, and seminar participants at the NBER Asset Pricing Meeting, University of Chicago, Cornell University, Duke/UNC Asset Pricing Conference, Federal Reserve Bank of New York, Rutgers University, University of Southern California, University of Virginia, and University of Wisconsin for helpful comments. We alone are responsible for all errors and omissions.