Consumption-Based Asset Pricing with Herd Behavior

This paper analyzes the link between herd behavior and asset prices in a multi-good pure-exchange economy where investors' preferences evolve over time in response to the consumption decisions of other investors. More precisely, the rule of updating preferences incorporates a bandwagon effect, that is, preferences for a good increase because other people consume the same good, and investors differ with respect to the intensity of herd behavior. The evolution of preferences interacts with standard forces of the market economy and produces interesting dynamics of asset prices: the model generates value and growth premium in the cross section of stock returns and momentum effect in the time series; the bandwagon effect in consumption leads to bandwagon effect in investor's portfolios, that is, when investors favor a specific good they also favor the stocks of the economic sector that produces that good. In this way, the model offers a possible explanation for the rise and fall of fashions in the stock market or, in an international finance framework, for the home bias in consumption and equity portfolios