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We introduce habit-formation in the three-period OLG borrowing-constrained framework of Constantinides et al. (2002) by allowing the utility of the middleaged (old) to depend on consumption when young (middle-aged). This specification enables us to separate the effect of the two habit parameters (middle-aged and old) since each representative age-group can face different levels of habit persistence. The two-habit setup underlines some important issues with regards to savings and security returns which do not always conform to the standard findings in the literature. In addition, the model produces equity premium consistent with US data for relatively small levels of risk aversion.We are grateful to John Donaldson for numerous comments and suggestions during the course of this research. We are especially thankful to the editor, John Doukas, and George Constantinides, the referee, for their various helpful comments and suggestions. Finally we also want to thank Richard Clarida, Dan O'Flaherty, Rajnish Mehra, Bruce Preston, Stijn Van Nieuwerburgh, and conference participants of the 2005 Financial Management Association.

We introduce a new preference structure—age‐dependent increasing risk aversion (IRA)—in a three‐period overlapping generations model with borrowing constraints, and examine the behavior of equity premium in this framework. We find that IRA preferences generate results that are more consistent with U.S. data for the equity premium, level of savings and portfolio shares, without assuming unreasonable levels of risk aversion. We find that the relative difference between the two risk aversions (how much more risk‐averse old agents are relative to the middle‐aged) matters more than the average risk aversion in the economy (how much more risk‐averse both cohorts are). Our findings are robust with respect to a number of model generalizations.

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We seek to explain a number of asset pricing anomalies – the equity premium puzzle, the risk‐free rate puzzle, and portfolio allocation puzzle – in a parsimonious overlapping generations (OLG) model with two key features: borrowing constraint and Epstein–Zin–Weil (1989) preference. The model goes a long way towards the resolution of these puzzles, and is able to simultaneously match asset pricing moments and individual portfolio decisions using reasonable values of parameters governing behavior. We find that the main driver of savings behavior, equity returns, and asset allocation is the relative difference between the two parameters: the level of relative risk aversion and the inverse of the elasticity of substitution.