[Financial Planning for the 100-Year Life] When to Increase the Proportion of Stocks in Household Financial Assets

Overvaluation in the Stock Market from 2020 to 2021
Undervaluation Phase at the End of Last Year as the Bubble Bursts

Young-Ik Kim, Adjunct Professor at Sogang University Graduate School of Economics.

The Bank of Korea recently released the 3rd quarter 2022 flow of funds data. The flow of funds provides a comprehensive view of where money is generated and where it flows across the entire country. It also shows how each economic agent, including households and businesses, raises and manages funds.

Households manage their financial assets by dividing them into bank deposits, stocks, bonds, and insurance. As of September last year, Korean households (including non-profit organizations) held financial assets worth 4,914 trillion won. Of this, 46% was held in cash and deposits, and 31% in insurance. The proportions of stocks and bonds were 20% and 2%, respectively. Compared to the end of 2021, the share of cash and deposits increased by about 3 percentage points, while the share of stocks decreased by the same amount. This was due to bank deposit interest rates rising significantly to around 5% last year and stock prices plunging.

The 20% stock proportion in Korean households' financial assets is higher than Japan's but much lower than that of the United States. As of the 3rd quarter last year, the stock share of Japanese households' financial assets was 14%. Unlike Japan, U.S. households held 50% of their assets in stocks.

The appropriate proportion of stocks in household assets varies by country and inevitably differs depending on each household's income and age group. However, since Korean stock prices have entered an undervalued range, it seems reasonable to slightly increase the stock proportion this year.

The appropriate level of the KOSPI can be estimated using nominal Gross Domestic Product (GDP), broad money supply (M2), and average daily export amounts. First, over the long term, the KOSPI's growth rate has slightly exceeded nominal GDP. Between 2000 and 2022, Korea's nominal GDP grew at an average annual rate of 5.8%. During the same period, the KOSPI's average annual growth rate was 6.9%. The KOSPI's growth rate was about 1 percentage point higher than nominal GDP growth.

Based on this, a regression analysis of the KOSPI against nominal GDP can estimate its appropriate level. In 2020 and 2021, the KOSPI was overvalued by 11.4% and 6.3%, respectively, relative to nominal GDP. Therefore, at that time, I advised investors to reduce their stock holdings. However, in 2022, stock prices plunged, and the KOSPI fell 24.4% below the estimated appropriate level based on nominal GDP. Over time, the KOSPI is expected to approach the appropriate level estimated by nominal GDP. Nominal GDP is expected to grow at about 3% annually over the next five years.

Next, stock prices have also entered an undervalued range relative to the money supply. The appropriate level can be gauged by dividing the KOSPI market capitalization by M2. Since 2005, the ratio of KOSPI market capitalization to nominal GDP averaged 58%. However, in the first half of 2021, this ratio rose to 66% due to a surge in stock prices. But in 2022, stock prices sharply declined, and by September, this ratio dropped to 46%. This indicates that the KOSPI is undervalued relative to the money supply as well.

Finally, the economic variable most highly correlated with the KOSPI is the average daily export amount. Analyzing data from 2005 to 2022 shows a correlation coefficient of 0.86 between these two variables, which is very high. In June 2021, the KOSPI overvalued the average daily export amount by 36%. However, after the stock price plunge, the KOSPI entered an undervalued range in the second half of 2022. It is estimated to have been undervalued by about 7.5% as of December last year.

Investment is a proper combination of returns and risks. Last year was a period when the KOSPI's overvaluation was corrected, so risk management was necessary. However, the current stock index is in an undervalued range. Over time, stock prices return to their proper levels. It seems to be a time when households can increase their stock holdings to some extent while pursuing returns.

Kim Young-ik, Adjunct Professor, Graduate School of Economics, Sogang University