Politics Can Sway Investing

It seems that in the upcoming presidential election, American voters will be faced with choosing between two candidates with the highest unfavorable ratings in history. It’s either that (at least if the parties’ national conventions go as expected), or a choice not to vote.

The unfavorable ratings of both candidates are creating a great amount of anxiety among voters, even those who actually favor one of the two front-runners. That’s because recent polls show a close race. The Real Clear Politics average poll results as of June 1 had Hillary Clinton ahead by a slim, point-and-a-half margin over Donald Trump: 44% versus 42.5%. That’s well within the margin of error.

As the director of research for The BAM Alliance, I’ve regularly been receiving emails and phone calls from clients and advisors (who are getting the same calls from their clients) worried about the impending “disaster” to the economy if one or the other (presumptive) candidate is elected. They want my view on what they should be doing with their portfolios to protect themselves.

What’s particularly interesting—and consistent with my prior experience, as well as the academic literature—is that those who favor Clinton are worried about the “disaster” that will occur in the economy and the stock market if Trump is elected, while those who favor Trump are concerned about the economic “disaster” that another eight years with a left-leaning Democrat in the White House would bring.

Political Bias Influences Investment Attitude

Many investors are unaware how their political biases can impact their investment decisions (usually with negative results). My experience has been that Republicans were much better investors during the Bush administration, and Democrats were much better investors during the Obama administration.

The reason is that when the party they favored was in power, they tended to be more optimistic. That led to a more disciplined investment approach, which helped them avoid panicked selling.

After all, we know that doing nothing (except rebalancing and tax managing, harvesting losses where appropriate) is more likely to prove productive than doing “something.” As the Oracle of Omaha, legendary investor Warren Buffett, stated in Berkshire Hathaway’s 1996 annual report: “Inactivity strikes us as intelligent behavior.”

Unfortunately, investors often make mistakes with their money because they aren’t aware of how decisions can be influenced by their beliefs and biases. The first step to eliminating—or at least minimizing—mistakes is to become cognizant of how our financial decisions are affected by our views, and then how those views may influence outcomes.

A 2012 study, “Political Climate, Optimism, and Investment Decisions,” showed that people’s optimism toward both the financial markets and the economy is dynamically influenced by their political affiliation and the existing political climate.

Using a large sample of UBS/Gallup survey data, and portfolio holdings and trading data from a large U.S. discount brokerage house, the study’s authors examined whether the changing expectations of U.S. households about the behavior of financial markets and the macroeconomy affect their investment decisions.

Study Results

Following is a summary of their findings:

• Individuals become more optimistic and perceive the markets to be less risky and more undervalued when their own party is in power. This leads them to take on more risk. They overweight stocks with higher systematic risk and exhibit a stronger preference for high market beta, small-cap and value stocks. Those investors also trade less frequently. That is a good thing, because the evidence demonstrates that the more individual investors trade, the worse they do.
• When the opposite party is in power, their perceived uncertainty levels increase and investors exhibit stronger behavioral biases, leading to poor investment decisions. The perception that economic uncertainty is high causes investors to be less likely to believe that a passive strategy (the one most likely to achieve the best results) will be profitable. That leads them to tilt their portfolios more toward familiar, local stocks and to trade more actively. And in an attempt to find managers that will outperform in uncertain markets, they select funds with higher expense ratios. The higher trading activity and higher expenses leads to worse performance.
• There are differences in the stock preferences of investors located in highly Republican and Democratic regions. Democrats are more likely to support environmental and labor protection while opposing tobacco use, firearms and defense. These values may lead those investors to overweight or underweight the stocks of companies associated with such issues. It’s possible that such investment distortions may be due to investors deriving utility from allocating their capital in ways consistent with their social and political values (socially responsible investing). However, it’s also possible that investors’ political values are influencing their perceptions of risk and return if they expect firms whose business is inconsistent with their values to be less profitable or riskier.

The following example demonstrates just how large an impact a shift in the political climate can have on the investment behavior of individual investors. Before the 2000 election results were announced, Democrats were slightly more optimistic than Republicans. However, soon after the announcement of George W. Bush’s win, the gap widened dramatically. Roughly 62% of Democrats were optimistic about the stock market in 2000, but that figure fell to just 36% in 2001. The optimism about the overall economy was similarly affected.

Summary

There is strong evidence that the political climate affects investors’ view of the economy and the stock market, and also impacts their investment behavior. Specifically, the returns of individual investors improve when the political regime favors their political party, and vice versa.

This result is due to two factors. When their party is in favor, they tend to increase exposure to systematic risk and thus earn higher returns. They also tend to use more passive strategies, reducing costs.

Being aware of your biases and acting accordingly can help you make better investment decisions. The bottom line is the evidence from this study suggests that, just as investors should not let the latest economic news cause them to abandon well-developed financial plans (shift their asset allocation), they shouldn’t let the political climate do so either.

This commentary originally appeared June 8 on ETF.com

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The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

© 2016, The BAM ALLIANCE

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