Discussion Papers

Findings from research and studies conducted at the Financial Research Center (FSA Institute) are organized and published as Discussion Papers to stimulate further discussion and comment.

The views expressed in the papers are those of the authors and do not necessarily reflect the views of the Financial Services Agency or the FSA Institute.

Discussion Papers (FY 2021)

No. Title/Author(s)
(June 2021)
Investment Behavior to Avoid Capital Loss and Optimal Portfolio Selection

Abstract | Full text (PDF:1.79MB)(Full text is available only in Japanese.)



Investment Behavior to Avoid Capital Loss and Optimal Portfolio Selection

YOSHINO Naoyuki, Director, Financial Research Center (FSA Institute)
TSUMAGARI Masaki, Deputy Director, Strategy Development Division, Strategy Development and Management Bureau, FSA

Avoiding capital loss, by all means, is a typical investment behavior prevailing among individuals/households, corporations, and institutional investors in Japan. We define ‘capital loss avoidance’ behavior in Japan as “investors always trying to invest in assets that can maintain positive returns" so that investment returns do not become negative, i.e., investment principal is always secured in any economic or market environment. In this paper, we theoretically explain that the behavior to avoid the risk of capital loss may lead to the loss of investment opportunities that provide higher rates of return (even after taking the risk into account). To this end, we use a simple portfolio model to show that the behavior of loss avoidance could be seen when actual risk-return profiles are overlooked. Furthermore, we compare the typical portfolio choice reflecting the loss avoidance behavior with alternative portfolio choices in the absence of such behavioral constraints. In the second half of the paper, we use empirical data from Japan’s stock market to illustrate empirically that in the long run there are alternative combination of portfolio choices with higher return and lower risk profile compared with a simple ‘loss avoiding’ investment choice, even if individual assets carry risk of capital loss. Data-oriented case analyses include; (i) a case when one of the assets carries risk of capital loss and (ii) a case when both assets carry risk of capital loss. The investment behavior to avoid the loss of principal of each asset in the short run may be theoretically/empirically distorting the optimal portfolio selection and hindering enhancement of asset management efficiency in Japan. When making asset management decisions, it is desirable to look at the longer-term moving average performance of five or ten years, rather than looking at the performance of a single year.

Keywords: investment behavior to avoid capital loss, long-term investment evaluation, optimal portfolio selection, risk diversification effect.

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