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I find asset pricing theory very vague and full of assumptions, especially the consumption-based modern theory. In its essence, the theory states that asset prices depend on the covariance between consumption and the asset's payoff - if an asset pays well in bad states of consumption, it warrants a higher price and vice versa. The logic behind this is ok, but what bugs me is that I don't see people behaving like this in reality, and I don't see any reason they should.

Most people who participate actively in the stock market, for example, are either traders working for an institution, or investors with a decent amount of extra capital (people rarely invest in the stock market if the amount of money invested would significantly affect their consumption). Now, I really don't think traders' or fund managers' consumption levels in bad economic states is much affected by their work performance. At least it's hard to see the link. Secondly, most private investors investing in the stock market have financial buffer - they are already backed up for recessions, and just want to see their extra money grow. They don't care that much if their investment pays off well in recessions particularly. If the investment shows up a profit, they are equally happy regardless of what the economic state is because that profit will not be used to improve their level of consumption in that particular time since they are already covered.

Am I missing something here? Do you agree with me? I know that behavioral finance probably answers many of my questions, but nevertheless, consumption-based pricing theory is taught in finance programs and serves as a fundamental theory of everything. Again, I think that the theory is otherwise sound but the assumption that people who make investment decisions are driven by their future consumption level in different economic states is vague.

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I can understand your concerns, but I think you are expecting too much from these theories. We cannot explain aggregate behavior from first principle based on a sound theory of individual decisions under uncertainty and I personally doubt that there will ever be such a Grand Unification in economics.

Consumption-based asset pricing models are more related to macroeconomics than microeconomics. The goal is not to depict how individual investors behave exactly, but to derive testable implications for aggregate market behavior. For example, one of the most restrictive versions is the one period CAPM, which is probably the most widely used asset pricing model out there. There is absolutely nothing realistic about the assumptions of the model, but it does serve as a guideline because the predictions it makes are sufficiently accurate for some applications.

Also, I wouldn't necessarily say that asset pricing is full of assumptions. There are only two fundamental assumptions: No arbitrage (or no-free lunch with vanishing risk) and more wealth is always preferred to less wealth. In this generality, however, not much can be said; nothing useful anyway. If you want strong implications you also need strong assumptions - it's always a trade-off - because we cannot verify theories by direct experimentation with economic systems.

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Consumption-based asset pricing theories are about representative agents, not necessarily about traders and investors in financial institutions. The agents are assumed to follow behaviors based on how people generally would decide whether to invest and how much to invest. The idea is that the average person in the economy does not invest for the joy of investing, in and of itself, nor do they save simply to be misers. Rather, they save and invest in anticipation that they will need to spend money in retirement or when unemployed. Thus, the theory is not about consumption today, necessarily, but about consumption in the future.

For instance, suppose I am employed in a highly cyclical sector. If there is a recession, I will be laid off. This can be thought of like a bond with a default rate conditional on the state of the economy. I will then need to spend money out of savings. If my savings are primarily invested in highly cyclical sectors, then I will be doubly exposed to the risks of a decline in the market. Effectively my bond (employment) will default (end) and my investments in cyclical sectors will fall. This will leave me less money to finance my consumption.

While these models are popular in academic finance programs, the techniques are not all that popular among practicing quants, except to the extent that they mirror conventional approaches.

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I understand all this, but at the same time, it is what still bugs me. You state that "Consumption-based asset pricing theories are about representative agents, not necessarily about traders and investors in financial institutions". But if a large part of decisions in the economy are made by people who have preferences differing from the people whose consumption is at stake and thus affecting asset prices, isn't it true that the scenario is not very representative at all? –  Investor Mar 12 at 21:45
    
A follow-up question: Let's say that the representative agent buys enough of an asset that perfectly negatively correlates with consumption. Thus, the agent is insured against recessions - their consumption will stay approximately the same. What then happens to the prices of all other assets, since there is no variation in consumption? Suddenly they are priced like risk-free assets (according to consumption-based model). Seems unlikely to me. Maybe I'm missing something? –  Investor Mar 12 at 21:50
    
@Investor To your first point, advocates of this approach would likely say that it is an abstraction that wouldn't substantially impact the analysis. Others (like yourself) may disagree with that assessment, but oh well. To your second point, this is not agent based modelling. Representative agents are be more-or-less alike. Same utility functions, same preferences, same expectations. Maybe different ages in overlappying generation models. For the most part, all the agents are exposed to the same consumption goods in the same way. –  John Mar 13 at 3:55
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Also, this theory isn't all that popular among practitioners. You'd get more information talking to some finance professors or something. –  John Mar 13 at 3:55

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