What is the greatest risk in investing in the Japanese stock market? Is it economic stagnation recurring or a sudden appreciation of the yen?

Okay, friend, you've hit the nail on the head. Regarding the risks of investing in the Japanese stock market, "economic stagnation" and "yen appreciation" are indeed the two biggest concerns for everyone. They're like two swords hanging over the Japanese stock market.

In my view, these two risks aren't an "either/or" situation; they are interconnected, representing a "surface and core issue." But if I absolutely had to say which one is the biggest, or which one is most direct for us overseas investors, my take is this:

In the short term, the most direct and painful risk is "sudden yen appreciation"; but in the long term, the most fundamental and fatal risk is "economic stagnation returning."

Let me explain this in plain language.

First, Sudden Yen Appreciation: This is the most direct, immediate "pain"

Think of yen appreciation as a "double whammy."

First Whammy: Hits Japanese Company Profits.

The Japanese stock market has many well-known giants like Toyota, Sony, Nintendo. They are major exporters, selling products worldwide and earning dollars and euros.

An analogy: Suppose Toyota makes $30,000 profit selling a car in the US.
- When the yen is weak (e.g., 1 USD = 150 JPY), bringing that $30,000 back to Japan translates to 30,000 x 150 = 4.5 million yen in revenue.
- If the yen suddenly appreciates (e.g., 1 USD = 120 JPY), that same $30,000 converts to only 30,000 x 120 = 3.6 million yen.

See? The car is the same, the dollars are the same, but the yen profit recorded on the company's financial statement instantly drops by 900,000 yen! Falling profits naturally make the stock price more likely to drop. That's why the Nikkei often "shudders" when the yen strengthens.

Second Whammy: Hits Our Returns as Overseas Investors.

This is especially important for us. We invest using our own currency (e.g., RMB), and ultimately, we need to convert back to realize gains.

Another example:
1. You invest 1 million yen in the Japanese stock market when the exchange rate is 1 USD = 150 JPY (equivalent to investing ~$6,667).
2. A year later, congratulations, your stocks are up 10%, so you have 1.1 million yen. Looks good, right?
3. But! During that year, the yen appreciated significantly, and the exchange rate became 1 USD = 120 JPY.
4. Now, when you convert your 1.1 million yen back to dollars, you only get 1,100,000 / 120 ≈ $9,167.
5. Wait, let's calculate: your initial investment was $6,667, now it's $9,167. That's a profit, isn't it?
Ah, apologies, my example above was backwards. Let's look at it from the correct perspective to feel the "pain":
Correct Example:
1. You invest $10,000 in the Japanese stock market when the exchange rate is 1 USD = 150 JPY, giving you 1.5 million yen.
2. A year later, your stocks are up 10%, so your account holds 1.5 million x 1.1 = 1.65 million yen.
3. But! The yen has appreciated significantly, and the exchange rate is now 1 USD = 120 JPY.
4. Converting your 1.65 million yen back to dollars gives you 1,650,000 / 120 = $13,750.
5. Your stocks gained 10%, but due to the exchange rate, your dollar principal only went from $10,000 to $13,750, resulting in an actual return of 37.5%.
Wait, that's still a gain! So is yen appreciation good for us?

Hold on, let's look at the worst-case scenario, which is also the most common one:

Yen appreciation -> Japanese exporter profits fall -> Stock prices drop.
The Most Realistic, Brutal Example:
1. You convert $10,000 to 1.5 million yen and invest it.
2. Then, the yen starts appreciating. Fearing falling profits, the market reacts, and your stocks drop 10%, leaving your account with 1.5 million x 0.9 = 1.35 million yen.
3. At this point, the exchange rate has become 1 USD = 120 JPY.
4. Feeling discouraged, you decide to sell your stocks and convert back to dollars, getting only 1,350,000 / 120 = $11,250.
5. See? Your stocks fell 10%, but because the exchange rate helped you a bit, you still ended up with a 12.5% gain.
So, is yen appreciation good or bad for us overseas investors?

The key is: which moves faster, the stock price decline or the exchange rate gain?

Typically, the panic caused by rapid yen appreciation leads to stock market declines that outweigh the benefits from the exchange rate. You gain from the currency move but lose even more on the stock price. That's why it's seen as a huge risk.

Now, Economic Stagnation Returning: This is the more fundamental, long-term "disease"

If yen appreciation is an "acute illness" – comes on fast and leaves fast – then economic stagnation is a "chronic disease." It determines the Japanese stock market's "constitution" and "ceiling."

The Engine Analogy: Think of the Japanese economy as a car, with the stock market as its passenger. The yen exchange rate is like the weather. Bad weather (yen appreciation) might slow the car down, but as long as the engine (economy) itself is strong, it can still move forward. But if the engine itself stalls or runs out of fuel (economic stagnation), forget moving forward – not sliding backward would be an achievement.
Why is Economic Stagnation the Fundamental Risk?
1. No Growth Story: Long-term stock market gains rely on sustained growth in company profits. If the entire national economy stops growing, most companies lose their growth momentum, and stock prices naturally can't rise. Think of Japan's "Lost Three Decades" – the stock market's long-term slump has its roots right here.
2. Weak Domestic Demand: Japan faces severe aging and population decline, meaning its domestic consumer market will shrink. Companies become overly reliant on overseas markets, making them highly sensitive to exchange rate fluctuations – bringing us back to the point above.
3. Limited Policy Tools: Precisely because the economy has been weak for so long, the Bank of Japan has maintained ultra-low interest rates and monetary easing. This, to some extent, fueled the recent yen depreciation and stock market rally. If the economy turns south again, what "strong medicine" does the central bank have left? The policy toolbox is nearly empty.

So, which risk is bigger?

My conclusion is:

For an investor seeking short-term gains, sudden yen appreciation is the more concrete, ever-present risk to guard against. It's like a ghost that can appear anytime, instantly evaporating paper profits or turning them into losses.

But for a value investor planning to hold long-term and betting on Japan's transformation, economic stagnation returning is the real "gray rhino" to worry about. If Japan's structural problems (aging, inefficiency, lack of innovation) remain unresolved, then no matter how hot the current market is, it might just be a flash in the pan, leading back to the path of the past few decades.

Simply put, yen appreciation determines "whether you lose money," while economic stagnation determines "whether you can make money."

Quick Summary

Sudden Yen Appreciation: Short-term risk, like an unexpected storm. Delivers a "double whammy" to exporters and overseas investors, directly impacting short-term returns.
Economic Stagnation Returning: Long-term risk, like the fertility of the soil. Determines the long-term potential and ultimate ceiling of the Japanese stock market.
Their Relationship: It's precisely because of long-term economic stagnation (poor soil) that constant monetary easing (watering) was needed, leading to yen depreciation (drought). If easing stops or even reverses (rate hikes), the weather changes abruptly (yen appreciation), and the stock market – like a crop artificially boosted by water – could collapse immediately.

Therefore, investing in the Japanese stock market requires keeping one eye on the road: one eye watching short-term currency fluctuations, and the other looking further ahead, observing whether Japan's economic "engine" has truly reignited.