DP13595 The Total Risk Premium Puzzle

Author(s): Òscar Jordà, Moritz Schularick, Alan M. Taylor
Publication Date: March 2019
Keyword(s): Consumption-based asset pricing, Equity premium, housing premium, risk aversion
JEL(s): E44, G12, G15, N20
Programme Areas: Financial Economics, Economic History, International Macroeconomics and Finance, Macroeconomics and Growth
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=13595

The risk premium puzzle is worse than you think. Using a new database for the U.S. and 15 other advanced economies from 1870 to the present that includes housing as well as equity returns (to capture the full risky capital portfolio of the representative agent), standard calculations using returns to total wealth and consumption show that: housing returns in the long run are comparable to those of equities, and yet housing returns have lower volatility and lower covariance with consumption growth than equities. The same applies to a weighted total-wealth portfolio, and over a range of horizons. As a result, the implied risk aversion parameters for housing wealth and total wealth are even larger than those for equities, often by a factor of 2 or more. We find that more exotic models cannot resolve these even bigger puzzles, and we see little role for limited participation, idiosyncratic housing risk, transaction costs, or liquidity premiums.