Preference for consumption predictability and the equity premium puzzle

This paper provides a solution to the equity premium puzzle. We modify the standard constant relative risk aversion utility function by assuming that the representative consumer also has a preference for consumption predictability. While keeping the conditional mean of the stochastic discount factor close to one, this feature not only reinforces consumption smoothing, but it also results in large increases in the variability of the stochastic discount factor which is crucial for this solution to the puzzle. The large increase in variability for the stochastic discount factor in our modified model is primarily determined by large, realized consumption forecast errors. Although these oversized forecast errors arise infrequently, when they do arise, they result in very high aversion to risk and enhanced interest in smoothing consumption. • Preference for consumption predictability solves the equity premium puzzle. • Unpredictability of consumption increases volatility of stochastic discount factor. • Realized, large consumption forecast errors induce consumers to hold less risk.