Swedroe: Ignore Politics In Investing

October 31, 2018

The economy is clearly doing well, with real GNP growing 4.1% in the second quarter and expected real growth of 3% in this quarter. In addition, unemployment has fallen to 3.7% (the lowest since 1969), and inflation remains well under control. In September, the Consumer Price Index for All Urban Consumers increased 0.1% on a seasonally adjusted basis, rising just 2.3% over the last 12 months.

Given these sets of facts, you would think investors’ views of the economic outlook would be good. And you would be both right and wrong!

Tale Of 2 Economies

The September monthly survey from Spectrem Group, which conducts ongoing primary research on investors, found amazingly disparate views on the economy and the outlook for stocks dependent on one’s political affiliation.

With a reading of 31 to 51 considered a bullish viewpoint, the latest Spectrem Affluent Household Outlook found that Republicans rated the economy at 56. Democrats appear to be living in an alternative universe, as their economic confidence rating was -31, with -31 to -51 considered the most bearish. A psychologist might diagnose this as a case of cognitive dissonance.

The problem is that such bearish views influence investment decisions. The survey found that almost 50% of Democrats were not investing. This compares with less than one-third of Republicans not investing.

The November and December 2016 Spectrem Affluent Investor Confidence and Millionaire Investor Confidence Indices provided further evidence of how political biases can impact investment decisions.

With Hillary Clinton’s 2016 election considered almost inevitable, prior to the election results being known, those identified as Democrats showed higher confidence than those identified as Republicans or Independents. This completely flipped after the election: Democrats registered a confidence reading of -10, while Republicans and Independents showed confidence readings of +9 and +15, respectively.

These findings should not really be a surprise, as they are entirely consistent with the academic literature.

The Evidence

The 2009 study by Yosef Bonaparte, Alok Kumar and Jeremy Page, “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 authors studied whether the changing expectations of U.S. households about the behavior of financial markets and the macroeconomy affect their investment decisions.

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, as 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 and higher expenses lead to worse performance.
  • There are differences in 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 that are 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 businesses are 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 impacts 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—about 62% of Democrats were optimistic about the stock market in the year 2000, and just 36% in 2001. The optimism about the overall economy was similarly affected.

Summary

There is clear evidence that the political climate affects investors’ views 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. And they tend to use more passive strategies, reducing costs.

Mistakes are often made because we are unaware that our decisions are being influenced by our beliefs and biases. The first step to eliminating, or at least minimizing, mistakes is to become aware of how our decisions are impacted by our views and how those views can influence outcomes. Being aware of your biases can help you make better investment decisions.

The bottom line is that the evidence suggests that, just as investors should not let the latest economic news cause them to abandon well-developed plans (shift their asset allocation), they should not let the political climate do so either.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

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