Explaining the Poor Performance of Consumption-based Asset Pricing Models.

We show that the external habit-formation model economy of Campbell and Cochrane (1999) can explain why the Capital Asset Pricing Model (CAPM) and its extensions are better approximate asset pricing models than is the standard consumption-based model. The model economy produces time-varying expected returns, tracked by the dividend-price ratio. Portfolio-based models capture some of this variation in state variables, which a state-independent function of consumption cannot capture. Therefore, though the consumption-based model and CAPM are both perfect conditional asset pricing models, the portfolio-based models are better approximate unconditional asset pricing models. [ABSTRACT FROM AUTHOR]