Consumption growth, preference for smoothing, changes in expectations and risk premium

• We link consumption growth, the consumption–wealth ratio, and asset returns.
• We capture concerns with states of the world in which consumption growth is low.
• We also track the preference of investors for a smooth consumption path.
• We uncover the role played by shifts in expectations about future returns.

This paper derives a relationship between consumption growth, the consumption–wealth ratio and its first-difference, and asset returns. Using quarterly data for sixteen OECD countries, we find that the three-factor asset pricing model explains a large fraction of the variation in real stock returns. The model captures: (i) the concerns of agents with states of the world in which consumption growth is low; (ii) the preference of investors for a smooth consumption path as implied by the intertemporal budget constraint; and (ii) the role played by shifts in expectations about future returns due to positive or negative news about their wealth.