Larry Swedroe reviews the evidence on how political biases can affect your investing.
“It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us.”
These words, from the opening of Charles Dickens’ “A Tale of Two Cities,” are among the most famous in all of English literature. Today they could easily apply to how investors view the outlook for the U.S. economy and our stock market.
Politics Affect Investors’ Market Perceptions
Whether you view the outlook for our economy and stock market as entering the best of times or the worst of times is highly dependent on your political perspective. Research on investor behavior has found that individuals become more optimistic and perceive the markets to be less risky and more undervalued when the party they favor is in power.
This leads them to take on more risk. They also trade less frequently, which is a good thing, because the evidence demonstrates that the more individuals trade, the worse they tend to do. But when the opposite party is in power, investors’ perceived uncertainty levels increase, and they exhibit stronger behavioral biases, leading to poor investment decisions.
You can observe just how strong the impact of these biases can be in the Spectrem Group’s December 2016 Affluent Investor and Millionaire Investor Confidence survey. Prior to the presidential election in November, survey respondents who identified as Democrats showed higher confidence than those who identified as Republicans or Independents. This completely flipped following the election, when Democrats registered a confidence reading of -10 while Republicans and Independents showed confidence readings of +9 and +15, respectively.
The February 2017 University of Michigan survey of consumer confidence provides further evidence. It showed Republican confidence sentiment at 120. This figure hadn’t topped 112 since 1952. For Democrats, the confidence reading was just 55.5, a level not seen since the last recession, when the economy was shedding 2 million jobs a month. Echoing Dickens’ now famous words, Republicans apparently think it’s the best economy in the postwar era, while Democrats seem to think it’s the worst since the financial crisis.
Here’s one more example. Before the 2000 election results were announced, Democrats were slightly more optimistic than Republicans. However, after the announcement of George W. Bush’s win, that changed dramatically. Roughly 62% of Democrats were optimistic about the stock market before the election, but that figure fell to just 36% in early 2001. The optimism about the overall economy was similarly affected.
The Problem Of Political Bias
Political biases create problems for investors, causing them to stray from even well-thought-out financial plans. Imagine the nervous investor who sold equities based on his views of a Trump presidency. While those who stayed disciplined have benefited from the rally, those who panicked and sold not only missed the bull market, they now face the incredibly difficult task of figuring out when it will once again be safe to invest.
It may also be worth noting that Warren Buffett’s Berkshire Hathaway has been persistently buying since the election, despite his having supported Hillary Clinton. Buffett doesn’t let his biases impact his investment decisions, which should be a clue as to whether you should allow your biases to do so.
I know of many investors with Republican/conservative leanings who were underinvested after President Obama was elected. Now it is investors with Democrat/liberal leanings who must face their fears.
It’s important to understand that, if you sell, unfortunately, there’s never a green flag that will tell you when it is safe to get back in. Never. Thus, the strategy most likely to allow you to achieve your goals is to have a plan that anticipates that there will be problems, and to not take more risk than you have the ability, willingness and need to take. Lastly, don’t pay attention to the news if doing so will cause your political beliefs to influence your investment decisions.
There’s strong evidence that the political climate impacts investors’ views of the economy and the stock market, and that it affects their investment behavior. Specifically, individual investors’ returns 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, investors tend to increase their exposure to systematic risk and, thus, earn higher returns. They also tend to use more passive strategies, reducing costs.
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 can influence outcomes. Being aware of your biases and acting accordingly can help you make better investment decisions.
The bottom line is that, just as you shouldn’t let the latest economic news cause you to abandon a well-developed financial plan and shift your asset allocation, you shouldn’t let the political climate do so either. As the “Oracle of Omaha” Warren Buffett stated in Berkshire Hathaway’s 1996 annual report, “Inactivity strikes us as intelligent behavior.”
This commentary originally appeared March 13 on ETF.com
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