The Consumption Risk of the Stock Market∗

This paper evaluates whether the medium-term risk of the stock market is sufficient to explain its high average rate of return relative to a risk-free investment. The medium-term risk of stocks is measured by the covariance of a market return over a quarter and consumption growth over horizons of one to three years. The medium-term risk of equity in aggregate consumption data is an order of magnitude higher than the contemporaneous risk. This higher level of risk is still insufficient to explain the average premium on equity. However, the medium-term risk of the stock market for households that hold equity directly is twice as large again and some point estimates are completely consistent with the high average return on equity and reasonable levels of risk aversion. ∗ I thank Pierre-Olivier Gourinchas, Christian Julliard, David Laibson, Monika Piazzesi, Bruce Preston, Christopher Sims, Nicholas Souleles, Mark Watson, Michael Woodford, and Annette Vissing Jorgensen for helpful discussions. I am also grateful to the discussants, editors, and participants in the Brookings Panel for their comments. Motohiro Yogo and Christian Julliard provided excellent research assistance in the summers of 2000 and 2001 respectively. Financial support was provided by National Science Foundation grant SES − 0096076 and by a National Bureau of Economic Research Aging and Health Economics Fellowship through National Institute on Aging grant number T32 AG00186. Princeton University, Department of Economics, Princeton, NJ 08544-1013; [email protected].