We fully characterize the equilibria in a gme between a fund manager of unknown ability who control the riskiness of his portfolio and investors who only observe realized returns. We derive two types of equilibria. The first one is such that (i) investors invest in the fund if the realized return falls within some interval, i.e., is neither too low nor too high, (ii) a good manager picks a portfolio of minimal riskiness and (iii) a bad manager picks a portfolio with higher risk, “gambling” on a lucky outcome. The second type of equilibrium is more traditional: (i) investors invest in the fund if the observed return is larger than some threshold, and (ii) good and bad managers choose the same risk level.

In this paper, I investigate the scope of a model with exogenous habit formation - or `catching up with the Joneses`, see Abel (1990) - to generate the observed equity premium as well as other key macroeconomic facts. Along the way, I derive restrictions for four out of eight parameters for a rather general preference specification of habit formation by imposing consistency with long-run growth, the leisure share, the aggregate Frisch elasticity of labor supply, the observed risk-free rate, and the observed Sharpe ratio. I show that a DSGE model with (exogenous and lagged) habits in both leisure and consumption, but not necessarily with additional persistence, is well capable of matching the observed asset market facts as well as macro facts, provided one allows for moderate real wage stickiness and provided one allows for sufficient curvature on preferences, as dictated by the asset market observations. Without wage stickiness, delivery on both the asset pricing implications as well as the macroeconomic implications seems to be much harder.