Asset Pricing with Habit-Dependent Preferences: Behavioral Foundations and Empirical Tests

This paper extends asset pricing models based on habit-dependent preferences in two new directions. First, previously proposed preference specifications are shown to be special cases of a more general model based on behavioral micro-foundations, that is a gain-loss model with habit utility as the reference state. Second, habit is modeled as the rational expectation of future consumption, rather than as a deterministic function of past consumption. The habit-depedent model with rational expectations habit can explain both stock and bond returns with low risk aversion, provided that loss aversion is reasonably large. JEL classification: E21, G12 First draft: August 26, 2004 This draft: September 26, 2004 ∗Finance Department, The Wharton School (e-mail: [email protected]). I thank Andrew Abel, John Campbell, Adam Szeidl, and Jessica Wachter for helpful comments and discussions.