[Financial Stability Report] "KOSPI Soared, But Individual Investors Flocked Overseas... Why?"

KOSPI Surged 28.9% in September?October, While S&P 500 Rose Only 5.9%
Despite the Rally, Retail Investors Were Net Sellers of Domestic Stocks and Net Buyers of Overseas Stocks
Recent Trend Shows Strengthening of 'Substitution Relationship' with Opposite Trading Directions Between Domestic and Overseas Stocks
When Short-Term Returns Exceed Long-Term Expectations, Pattern Shifts to Selling Domestic Stocks and Buying Overseas Stocks
Continued Expectations of High Exchange Rates Fuel Hopes for Both Investment Returns and Forex Gains

There is an analysis that the recent sharp rise in the domestic stock market, which has a relatively low long-term expected return, has actually strengthened profit-taking movements among domestic investors. The proceeds from profit-taking are being reinvested in the U.S. stock market, fueling the "Seohakgaemi" (Korean retail investors investing in overseas stocks) phenomenon. Regarding the recent won-dollar exchange rate, which has been fluctuating above 1,480 won, it is diagnosed that expectations of continued high exchange rates have increased hopes for foreign exchange gains on investment returns, further fueling the Seohakgaemi wave. The Bank of Korea stated that if the gap in expected returns between the Korean and U.S. stock markets narrows, the repatriation of individual investment funds to the domestic market could become smoother. However, it pointed out that since such expectations have formed over a long period, policy efforts to improve systems, such as enhancing corporate governance and expanding shareholder returns, must be pursued in parallel.

According to the Financial Stability Report released by the Bank of Korea on the 23rd, even though the KOSPI index surged by 28.9% between September and October this year-significantly outpacing the U.S. S&P 500’s 5.9% rise-individual investors were net sellers of domestic stocks and net buyers of overseas stocks. The Bank of Korea analyzed that while there can be a "complementary relationship," where net investment in both domestic and overseas stocks increases simultaneously, and a "substitution relationship," where an increase in one leads to a decrease in the other, the substitution relationship has recently become more pronounced.

Since 2020, the investment pattern of individuals in domestic and overseas stocks was mainly a complementary relationship, with net purchases in both markets. However, recently, there has been a temporary reversal in trading directions between domestic and overseas stocks, strengthening the substitution relationship. During 2020-2021, the net investment by individuals in overseas stocks exceeded ten times that of 2018-2019. At the same time, individuals also made large net purchases of domestic stocks, showing a pattern of net buying in both markets. In contrast, from February to July 2024, individuals were net sellers of domestic stocks by 14 trillion won and net buyers of overseas stocks by 8.3 billion dollars. From July to October this year, individual investors continued this opposite trading pattern, being net sellers of domestic stocks by 23 trillion won and net buyers of overseas stocks by 10.3 billion dollars.

On the 23rd, the status board in the dealing room of Hana Bank in Jung-gu, Seoul, displayed the won-dollar exchange rate and the KOSPI index.

The complementary relationship in the past between individual investors’ domestic and overseas stock investments was influenced by factors such as increased domestic liquidity and the effects of diversification. During periods of expanded domestic liquidity, individual investors increased net purchases in both domestic and overseas stocks, strengthening the complementary relationship. Jang Jeongsu, Deputy Governor of the Bank of Korea, pointed out, "The diversification effect that arises when holding both domestic and overseas stocks appears to have contributed to the formation of a complementary relationship," and added, "For U.S. stocks, which account for the majority of overseas investments by domestic individual investors, the correlation in returns (including exchange rate gains) with domestic stocks is lower than that with Japanese or German stocks, so domestic investors can expect a relatively greater diversification effect."

The recent strengthening of the substitution relationship between individual investors’ domestic and overseas stock investments has been driven by factors such as differences in returns and exchange rates. Due to the long-term gap in returns, investors’ expectations for returns have been fixed lower for the Korean stock market and higher for the U.S. stock market. As a result, when the short-term return of the domestic stock market rises more than the long-term expected return, a pattern emerges where domestic stocks are sold and overseas stocks are bought. This incentive was particularly strong during September and October this year, when domestic stock prices rose much more sharply than in the U.S., making the substitution effect between domestic and overseas stocks more pronounced. Recently, as the exchange rate has risen sharply, expectations of continued high exchange rates have persisted. The Bank of Korea analyzed that, when purchasing overseas stocks, investors can expect not only stock investment returns but also foreign exchange gains, thereby strengthening the relative advantage of overseas stocks.

The Bank of Korea empirically analyzed the factors influencing individuals’ net investment in domestic and overseas stocks and found that, as the long-term return gap between domestic and overseas stocks widened, both "momentum buying" and "profit-taking" effects appeared depending on short-term return fluctuations. Both domestic (KOSPI) and overseas (S&P 500) stocks showed increases or decreases in net investment depending on the difference between short- and long-term returns, confirming the effect of expected returns based on long-term performance. However, when short-term returns rise, net investment in overseas stocks tends to increase (+), while net investment in domestic stocks tends to decrease (-). This suggests that, when both markets rise simultaneously, profit-taking sales in domestic stocks and momentum buying in overseas stocks can occur.

Deputy Governor Jang stated, "As the gap in expected returns between the Korean and U.S. stock markets has persisted for a long time and domestic stock prices have surged in the short term, opposite trading patterns between the two have emerged. This suggests that if the gap in expected returns narrows, the repatriation of individual investment funds to the domestic market could become smoother." However, he emphasized, "Since this gap in expected returns has formed over a long period, it is difficult to change investors’ expectations with only temporary improvements in returns. Policy efforts to improve systems, such as enhancing corporate governance and expanding shareholder returns, are needed to boost the long-term performance and stability of the domestic capital market."