Risk and the consumption, saving, and portfolio choices of American households.

• Author: Parker, Jonathan A.
• Position: Research Summaries

In the past few years, U.S. households have faced an enormous amount of macroeconomic uncertainty. The financial crisis, the Great Recession, and the European debt crisis together have caused large changes in asset prices and incomes, increases in market volatility, and significant uncertainty about government policies. My research considers how consumption and saving behaviors respond to risk and to government policies, as well as how the risks that households face are evolving. Here I discuss four topics more specifically: How do households allocate their savings in response to different risks across different stocks? How do households (mis) perceive risk and how does this affect their behavior? How effective was the government stabilization policy of distributing tax rebates at generating household spending? And how have changes in the labor market and increasing inequality in particular changed which households bear macroeconomic risks?

Saving, Portfolios, and Risk

Different types of stocks traded on the U.S. stock market can exhibit quite different average returns over long periods, differences that persist out of sample, are highly statistically significant, and can be as much as 10 percent per year. Such differences ought to be understandable from the saving and portfolio choices of households, choices which in turn presumably are determined by differences in the riskiness of different stocks. That is,

people should pay less for stocks that are more risky, and we should observe risky stocks on average earning higher rates of return. But then the key issue becomes how we measure riskiness.

The central view in economics is that people save to support future consumption, which implies that we should be able to explain differences in expected returns across stocks by the risk that each investment poses for future consumption, or equivalently by the extent to which people's spending on consumption drops when the return is low and rises when the return is high. Such risky stocks are said to have high "consumption betas." Unfortunately, this theory does not work well in many dimensions. Groups of stocks with quite different average returns have similar consumption risk (betas). And the average returns on the stock market as a whole (relative to safe, short-term interest rates) are too large to be justified by its consumption risk, unless households are assumed to be implausibly risk averse.

My own work argues that in evaluating this theoretical insight--that consumption risk determines how attractive an asset is and thus its price and average return--it makes more sense to measure ultimate consumption risk rather than the usual contemporaneous consumption risk. I find that ultimate consumption risk largely does explain expected returns on stocks. The argument is that when a stock declines, measured consumer spending may take a while to fall for reasons that range from delay in measurement to hard-to-adjust commitments to spend to inattention or near rationality. The finding starts by defining ultimate consumption risk as the change in consumption over a three-year horizon that includes and follows a return that occurs over three months. Three years seems the right balance between the increased signal about consumption risk from a longer horizon and the greater mis-measurement of consumption risk that comes from overlapping data and unexpected movements of consumption following an asset return.

I show that measures of the ultimate consumption risk of the stock market come closer to making the consumption-based understanding of portfolio choice consistent with observed total stock market returns. I find that the ultimate consumption risk of the stock market is about six times what was previously measured by contemporaneous consumption risk. (1) Furthermore, considering only the ultimate consumption risk of those households that actually participate in the stock market yields an even higher measure of consumption risk. (2) Finally, market returns are higher following periods in which ultimate consumption risk is higher, although that relationship is statistically weak. (3)

Returning to the wide differences in average returns across different stocks, Christian Julliard and I show that ultimate consumption betas do a good job of explaining the differences in expected returns across stocks. (4) Differences...