The Returns on Human Capital: Good News on Wall Street is Bad News on Main Street

Abstract

We use a standard single-agent model to conduct a simple consumption growth accounting exercise. Consumption growth is driven by news about current and expected future returns on the market portfolio. The market portfolio includes financial and human wealth. We impute the residual of consumption growth innovations that cannot be attributed to either news about financial asset returns or future labor income growth to news about expected future returns on human wealth, and we back out the implied human wealth and market return process. This accounting procedure only depends on the agent's willingness to substitute consumption over time, not her consumption risk preferences. We find that innovations in current and future human wealth returns are negatively correlated with innovations in current and future financial asset returns, regardless of the elasticity of intertemporal substitution. The evidence from the cross-section of stock returns suggests that the market return we back out of aggregate consumption innovations is a better measure of market risk than the return on the stock market.

An Estimation of Economic Models with Recursive Preferences

“…This later finding is consistent with results in Lustig and Van Nieuwerburgh (2008), discussed further below.…”

Hedging labor income risk

“…Recently, a literature has studied the general equilibrium asset pricing implications of human capital risk, see Dreze (1979), Danthine and Donaldson (2002), Qin (2002), Santos and Veronesi (2006), Lustig and Van Nieuwerbugh (2008), Parlour andWalden (2011), Palacios (2010), and Berk and Walden (2010). These studies examine the interplay between labor income risk and stock market risk in agents' portfolio problems.…”

“…By contrast, Jagannathan and Wang (1996) find that an aggregate labor factor significantly improves the performance of a conditional CAPM in explaining the cross section of expected returns. Lustig and Van Nieuwerbugh (2008) argue that in a standard representative agent model the observed aggregate consumption dynamics are inconsistent with a positive relation between returns on human capital and financial returns. On the other hand, using co-integration analysis Benzoni, Collin-Dufresne, and Goldstein (2007) argue that returns to human capital and financial returns should be highly correlated, which may explain the hump-shape lifecycle portfolio holdings of households.…”

Non-Diversifiable Volatility Risk and Risk Premiums at Earnings Announcements

“…Pan (2002) interprets this finding as indicating that option traders demand a premium for holding the index options over a period that exposes them to non-diversifiable volatility risk. Bansal and Yaron (2004), Bansal, Khatchatrian, and Yaron (2005), Lustig and Van Nieuwerburgh (2008), and Bansal, Kiku, Shaliastovich, and Yaron (2012) explain why investors pay premiums to hedge against increases in market volatility. These studies explain that market volatility carries a risk premium because market volatility measures shocks to economic growth and aggregate utility, and Bansal et al (2012) show that high market volatility coincides with increased investment risk and significant declines in expected consumption.…”