Non-linear Dependence and Portfolio Decisions over the Life-Cycle

Using the Panel Study of Income Dynamics Survey, we reveal the non-linear dependence, between-squares correlation, between stock returns and earning risk exists. To understand how this non-linear dependence affects household life-cycle profile, we develop a life-cycle model that incorporates between-squares correlation and shows that this non-linear dependence can explain low participation rate and moderate risky asset shares. Empirical studies support the model’s predictions that households with higher between-squares correlations are less likely to participate in the stock market and lower their risky asset holdings conditional on participation.