The Consumption Risk of the

OVER THE PAST century in the United States, the average annual return on the stock market has exceeded that on short-term government bonds by 6 percentage points. The natural economic explanation for the premium on equity is the greater risks associated with investing in the stock market. However, the large premium that we observe cannot be explained by the canonical, consumption-based asset pricing model. Risk is best measured as the extent to which a return alters marginal utility. Since marginal util-ity is closely related to consumption, and consumption moves little with returns, the measured risk of the stock market is small.1 One common informal interpretation of this equity premium puzzle is that stocks are a good deal. In this view, the model is taken as a reason-ably accurate description of optimal behavior and a poor description of actual behavior. This normative view of the model and the data implies that households should increase their holdings of equity and even borrow to invest in the stock market.2 Such thinking has also entered important area