Asset Return Predictability in a Heterogeneous Agent Equilibrium Model

We use a general equilibrium model as a laboratory for generating predictable excess returns and for assessing the properties of the estimated consumption/portfolio rules, under both the empirical and the true dynamics of excess returns. The advantage of this approach, relative to the existing literature, is that the equilibrium model delineates the precise nature of the risk/return trade-off within an optimizing setting that endogenizes return predictability. In the experiments that we consider, the estimation issues are so severe that simple unconditional consumption and portfolio rules actually outperform (in a utility cost sense) both simple and bias-corrected empirical estimates of conditionally optimal policies.