The Dynamic of the Equity Premium: Is it Habit Formation or Loss Aversion?

The large spread between equity returns and risk free rates observed in most stock markets (the "equity premium puzzle") has been subject of intense debates. Two main families of models claim to solve this puzzle: habit formation models and loss aversion models. The goal of this paper is to assess empirically which of them fits the observed excess returns best. For that, I first show how to express both models in the same form, namely as linear stochastic discount factor models. This form has the main advantage to give explicit and testable constraints for the excess return dynamic. I then comparethe theoretical dynamic generated by these models with the observed dynamic. I find that the external habit model and a loss aversion model with a reference level based on past consumption are not likely to correspond to the observed data. In opposition, a loss aversion model with a reference level based on expected consumption and, to some extend, the internal habit model could fit the observed excess return dynamic.