John Cochrane: prediction

Transcript context

…There are habit formation theories of equity returns, right? As you well know. The notion that the return on equity is so much higher than the return on bonds because if you suffered losses on equity, it would disrupt your habits. In a way, there’s a form of risk aversion that doesn’t exactly translate into the inverse of the discount rate. You know all that. Now, having observed almost a year of pandemic behavior, do you now find habit formation theories more or less convincing? Let me clarify. The essence of the habit — and this is a paper that John Campbell and I wrote in the 1990s — what we were trying to get at was not so much the level of the equity premium — why do stocks seem to pay reliably more than bonds, so much for so long? It doesn’t do a great job of that. What it does a great job of is capturing what the essence of recessions is, and that’s a time when people get scared. It’s a variation in risk aversion. When you think about what happens in a recession, what happened last March, what happened in 2008, what happens in every recession — it’s not so much that people want to consume less today and consume more of tomorrow’s savings. It’s people get scared. They don’t want to hold risky assets. They want to hold safe assets. They act as if their risk aversion has gotten higher, and that’s what habits capture. As consumption goes down relative to what you’re used to, people get more risk-averse, unwilling to take risks on stocks going forward. So the stock market goes down much more than the economy goes down because recessions are mild, and that’s really puzzling. People keep saying, “Oh, this is the worst economy.” No, the economy — we’re back down to the level of 2017. Why do these temporary fluctuations make asset prices go so crazy? I think there’s something deep in that, and when stocks went down in March, I think people were scared as heck. Whether the mechanism is habits or whether the mechanism is something involving leverage and risk-bearing capacity in financial markets is less important. That was the deep point of the paper, which, of course, I’m going to keep saying I think is right. I’m prejudiced in favor of it. People do, but I think it’s a deep feature. I think there’s something deep to it that when you are forced . . . Even a middle-income person in America is vastly better off than the average person in India. Yet, if you take somebody who’s earning $200,000 a year and make them earn $50,000 a year, this feels like a disaster to them. As opposed to, you take an average person in a village in India, and they get to earn $50,000 a year — they feel wonderful. The fact that people’s feelings about their consumption level and their actions, which is what counts in economics — their wanting to avoid a disaster depends on their experience of their recent past. I still like that idea. Here’s a question from a reader. To paraphrase, “Finance was really exciting in the ’70s and ’80s. There was CAPM, Black–Scholes, prospect theory, et cetera, but what big exciting things have happened since? Where should we be looking for the next great innovation in finance?”…

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