Habit formation: a resolution of the equity premium puzzle?

We explore how the introduction of habit preferences into the simple intertemporal consumption-based capital asset pricing model "solves" the equity premium and risk-free rate puzzles. While agents with time-separable preferences care only about the overall volatility of consumption, we show that agents with habit preferences care not only about overall volatility, but also about the temporal distribution of that volatility. Specifically, habit agents are much more averse to high-frequency fluctuations than to low-frequency fluctuations. In fact, the size of the equity premium in the habit model is determined by a relatively insignificant amount of high-frequency volatility in U.S. consumption. (C) 2002 Elsevier Science B.V. All rights reserved.