Investor Information, Long-Run Risk, and the Duration fo Risky Assets

Value stocks have higher average returns than growth stocks. At the same time, the duration of value stocks' cash flows is considerably shorter than that of growth stocks. We show that when investors can fully distinguish short- and long-run consumption risk components of dividend growth innovations, only exposure to long-run consumption risk generates significant risk premia, implying that high-return value stocks should be long-duration assets, contrary to the historical data. By contrast, when investors observe the change in consumption and dividends each period but not the individual components of that change (limited information), exposure to short-run risk can generate large risk premia, implying that value stocks become short-duration assets while growth stocks are long-duration assets, as in the data. The limited information specifications we explore are not only consistent with the cash flow duration properties of value and growth stocks, they also explain the observed value premium, the higher Sharpe ratios of value stocks, the failure of the CAPM to account for the value premium, and the success of the HML factor of Fama and French (1993) in explaining the value premium.