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