Can Heterogeneity, Undiversified Risk, and Trading Frictions Solve the Equity Premium Puzzle?

Can the historical equity premium be explained as a rational equilibrium outcome when risk-averse agents with conventional preferences are faced with non-diversifiable sources of risk (e.g., from labor or entrepreneurial income), and when trading frictions prevent them from using financial assets to effectively self-insure transitory shocks? Our research suggests that it is difficult to generate the historical equity premium in realistically parameterized models of this sort. Nevertheless, investigations of these factors clearly reveal the ingredients necessary for any consumption-based model to match returns data. Using simplified versions of some of our earlier models and other models in the literature, in this paper we illustrate the promise and limitations of incomplete risk diversification and trading frictions as explanations for the equity premium puzzle. We also present new results on the likely importance of entrepreneurial income risk.