[This paper introduces a consumption-based capital asset pricing model (CCAPM) that combines undiversifiable income shocks and external habit formation. Using US state-level data, the paper provides realistic estimates for preference parameters when the external habit of the state investors is based on the consumption of the four Census regions. The model also implies four asset pricing factors: The cross-sectional means of consumption growth and habit growth (capturing national systematic risk) and the cross-sectional variances of consumption growth and habit growth (capturing regional systematic risk). This four-factor model has greater power in explaining expected returns than the CCAPM described in Breeden(1979).]

[We investigate whether the adverse effects of investors' behavioral biases extend beyond the domain of financial markets to the broad macro-economy. Focusing on the income risk-sharing role of financial markets, we find that risk sharing is higher (more than double) in U.S. states where investors are more sophisticated and exhibit weaker behavioral biases. The potential for risk sharing varies geographically, but states with better risk-sharing opportunities are able to achieve higher levels of risk sharing only when investors in those states are more sophisticated. Collectively, these results indicate that investors' aggregate behavioral biases and their lack of financial sophistication adversely affect the local macro-economy.]

This paper introduces a consumption-based capital asset pricing model (CCAPM) that combines undiversifiable income shocks and external habit formation. Using US state-level data, the paper provides realistic estimates for preference parameters when the external habit of the state investors is based on the consumption of the four Census regions. The model also implies four asset pricing factors: the cross-sectional means of consumption growth and habit growth (capturing national systematic risk) and the cross-sectional variances of consumption growth and habit growth (capturing regional systematic risk). This four-factor model has greater power in explaining expected returns than the CCAPM described in Breeden (1979). , Oxford University Press.

We propose a novel human capital model that decomposes aggregate income risk into highand low-income risk. We find that high-income risk is priced, while low-income risk is insignificant. The high-income factor alone explains 77% of the cross-sectional variation in the twenty-five size and book-to-market portfolios, earns a risk premium of about 7% per year, and its pricing power extends to the full cross-section of individual stocks. It is also related to the value factor, suggesting that the value premium might be compensation for income risk. Overall, our evidence indicates that high-income risk is an important macroeconomic risk factor.

Using a demographics-based proxy for smartness, we show that the portfolio distortions of “smart” investors reflect an informational advantage, while the distortions of “dumb” investors reflect psychological biases. Specifically, smart investors outperform dumb investors by about 3% annually on a risk-adjusted basis. Furthermore, among investors with high portfolio distortions, smart investors outperform passive benchmarks by 2%, and the smart-dumb performance differential is 5%. At the stock level, a portfolio of stocks with smart investor clientele outperforms the dumb clientele portfolio by 3.50% annually. These findings suggest that behavioral and information-based explanations for portfolio distortions apply to distinct subsets of investors.

We investigate whether the adverse effects of investors' behavioral biases extend beyond the domain of financial markets to the broad macro-economy. Focusing on the income risk-sharing role of financial markets, we find that risk sharing is higher (more than double) in U.S. states where investors are more sophisticated and exhibit weaker behavioral biases. The potential for risk sharing varies geographically, but states with better risk-sharing opportunities are able to achieve higher levels of risk sharing only when investors in those states are more sophisticated. Collectively, these results indicate that investors' aggregate behavioral biases and their lack of financial sophistication adversely affect the local macro-economy. The Author 2011. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: [email protected]., Oxford University Press.

Contrary to the predictions of traditional life-cycle models, household consumption is excessively sensitive to current income. Similarly, weak evidence of income hedging runs against standard portfolio theory. We link these two puzzles by modifying the theoretical framework of Viceira (2001) to study how consumption-income sensitivities generated by income in the utility function affect households' portfolio choices. Empirically, we find that consumption-income sensitivities affect asset allocation through the income hedging channel. In particular, we show that the interaction between consumption-income sensitivity and the correlation of income growth to stock market returns is an important explanatory variable for households' stock market holdings. Received October 20, 2016; editorial decision April 25, 2018 by Editor Wayne Ferson.

This paper examines the investment decisions of older individual investors. We find that older and experienced investors are more likely to follow rules of thumb that reflect greater investment knowledge. However, older investors are less effective in applying their investment knowledge and exhibit worse investment skill, especially if they are less educated, earn lower income, and belong to minority racial/ethnic groups. Overall, the adverse effects of aging dominate the positive effects of experience. These results indicate that older investors' portfolio decisions reflect greater knowledge about investing, but investment skill deteriorates with age due to the adverse effects of cognitive aging.

This study examines whether local stock returns vary with local business cycles in a predictable manner. We find that U.S. state portfolios earn higher future returns when state‐level unemployment rates are higher and housing collateral ratios are lower. During the 1978 to 2009 period, geography‐based trading strategies earn annualized risk‐adjusted returns of 5%. This abnormal performance reflects time‐varying systematic risks and local‐trading induced mispricing. Consistent with the mispricing explanation, the evidence of predictability is stronger among firms with low visibility and high local ownership. Nonlocal domestic and foreign investors arbitrage away the predictable patterns in local returns in 1 year.

We examine whether the decision to participate in the stock market and other related portfolio decisions are influenced by income hedging motives. Economic theory predicts that the market participation propensity should increase as the correlation between income growth and stock market returns decreases. Surprisingly, empirical studies find limited support for the income hedging motive. Using a rich, unique Dutch data set and the National Longitudinal Survey of the Youth (NLSY) from the United States, we show that when the income-return correlation is low, individuals exhibit a greater propensity to participate in the market and allocate a larger proportion of their wealth to risky assets. Even when the income risk is high, individuals exhibit a higher propensity to participate in the market when the hedging potential is high. These findings suggest that income hedging is an important determinant of stock market participation and asset allocation decisions.