Time Varying Prospective Utility and Optimal Asset Allocation for Stocks and Bonds: The Case of Australia and Japan, 1926-1995
38 Pages Posted: 13 Aug 2012
Date Written: August 6th, 2012
Many of the empirical investigations in behavioural finance are focused on US markets; with their focus on investor psychology, biases and heuristics these explanations may well not be robust when exposed to different countries, races and cultures. This paper investigates a popular explanation for the equity risk premium, namely Myopic Loss Aversion, in the two very different market environments of Australia and Japan. We also extend previous studies by explicitly allowing for time-varying distributions of asset returns. We present evidence that the concept of the frequency of portfolio evaluation required to produce indifference (in Prospective Utility terms) between Stocks and Bonds is highly dependent upon the sample period. For each of these two Pacific Rim markets, we pose two questions - given prospect theory preferences, taking account of a selection of plausible evaluation periods, how do the prospective utilities of stock, bond and optimally mixed portfolios evolve with time, and how does the optimum allocation ratio of stocks in a mixed stock/bond portfolio vary? Our asset allocation profiles indicate both distinctions and similarities between the markets of Australia and Japan; and (by reference to earlier work) differing patterns of behaviour of the Australasian markets when compared to those of the U.S. and U.K. However, perhaps the biggest surprise, given how different the political, cultural and investment experiences of these countries are, is how similar are the optimal asset allocations for much of the time.
Keywords: prospective utility, loss aversion, myopia, demographics, equity risk premium
JEL Classification: G10, G12, G15
Suggested Citation: Suggested Citation