THE JOURNAL OF FINANCE • VOL. LIX, NO. 6 • DECEMBER 2004 Luxury Goods and the Equity Premium

This paper evaluates the equity premium using novel data on the consumption of luxury goods. Specifying utility as a nonhomothetic function of both luxury and basic consumption goods, we derive pricing equations and evaluate the risk of holding eq-uity. Household survey and national accounts data mostly reflect basic consumption, and therefore overstate the risk aversion necessary to match the observed equity pre-mium. The risk aversion implied by the consumption of luxury goods is more than an order of magnitude less than that implied by national accounts data. For the very rich, the equity premium is much less of a puzzle. AS DEMONSTRATED BY GROSSMAN AND SHILLER (1981), SHILLER (1982), Mehra and Prescott (1985), and the extensive literature that follows, the risk of the stock market as measured by its co-movement with aggregate consumption is in-sufficient to justify the extent to which its average return exceeds the return on short-term government debt. We propose a partial resolution to this equity premium puzzle by distinguishing between the consumption of basic goods an