Politics is a polarizing subject that elicits strong emotional response from most individuals. Merely uttering the names “Obama” or “Trump” is bound to get the juices flowing for many readers. Trusted advisors have the dual responsibility of ensuring they overcome these natural human instincts themselves as they act in a fiduciary capacity while also helping their clients overcome them when making financial decisions. Being a fiduciary entails making significant decisions on how to manage wealth for the benefit of grantors and beneficiaries that may impact many generations to come. Indulging in one’s emotions tied to the political landscape isn’t only imprudent but also can be very costly.
Polls and studies have illustrated that political biases impact one’s judgment. In a Quinnipiac University poll from August 2019,1 there was a large gap on how Republicans and Democrats perceived the state of the economy. In the study, 43% of Republicans described the economy as “excellent,” and another 45% described it as “good.” However, among Democrats, just 2% described the state of the economy as “excellent,” and 37% said it was “good.” Roughly 60% of Democrats thought it was “not so good” or “poor.” Overall, 88% of Republicans used positive language for the state of the economy, while only 39% of Democrats did the same. Similarly, a 2017 study in the Journal of Financial Markets found that in the last years of Bill Clinton’s presidency, Democrats were more optimistic about the economy than Republicans. However, immediately following George W. Bush’s win over Al Gore in the 2000 election, the Republicans became more optimistic.2 We’re all living in the same economy, but our political affiliation can strongly influence our view of it.
Professional investors aren’t immune from having politics impact their thinking. A study in the Journal of Banking and Finance found that a hedge fund manager’s political affiliation “can influence the portfolio decisions of even those at the very top of the financial sophistication ladder.”3 The study noted a direct correlation between the type of stocks professional money managers select and their political perspectives. This is especially interesting because hedge funds have incentive fees that serve as motivators to outperform various benchmarks. Letting politics impact your paycheck seems unthinkable. However, despite the incentives, hedge fund manager thinking is also marred by political bias.
Historical Perspective
Understanding history provides a helpful context when making investment decisions and advising clients on how to manage their wealth. The advisor can strategically talk through the political climate in a level-headed manner and provide a data-filled perspective that will help guide future investment decisions.
There have been 58 presidential elections throughout history, with the Republicans and Democrats tied at 24 wins each. (Note: The 48 total wins by Republicans and Democrats don’t sum to the total number of elections because different parties existed in the country’s early days.) It’s also worth comparing the first two years of the presidential cycle to the full four, because the Senate and House can change halfway through due to the midterm elections.
According to a February 2020 paper by Fidelity, when the Republicans won the presidency and held the majority in both the House and Senate, which happened 16 times, the 2-year market return was approximately 12% annually.4 During a Democratic sweep, which occurred 19 times, there was an approximately 3.5% annual return for the first two years. However, after a full 4-year presidential cycle, the annualized returns for a one-party sweep were much closer at 8.6% for Republicans and 8.2% for Democrats. When Republicans won the presidency without a majority in the House or Senate, there was a 2-year return of approximately 1%. On the other hand, a Democratic win under the same scenario has produced a 2-year return of 14.5%. However, after a 4-year presidential cycle, the annualized returns are again similar at 8.7% and 10.9% for Republicans and Democrats, respectively.
Overall, factoring in all presidencies, and regardless of whether there was a one-party sweep of the House or Senate, the market did better over the first 2-year period when there was a Republican win. Those periods show an 8.3% annualized return as compared with 5.8% for Democratic wins. However, over the full 4-year terms, the averages are nearly equal at 8.6% for a Republican presidency versus 8.8% for a Democratic presidency.5
There are an infinite number of statistics that one can analyze from the markets. There are also plenty of ways, such as merely changing the start and end date slightly or reframing the data, to manipulate the numbers to prove one’s point. For example, since 1925, during a presidential election year, the market was up an average of 17.9% when a Republican was elected versus an average of -2.7% when a Democrat was elected. However, during the first year of a president’s term, the market was up an average of only 2.6% when there was a Republican compared to 22.1% for a Democrat. The analyst’s political leanings could certainly impact whether she chooses to focus on the annual period preceding or following the elections.
The most important data point, however, is the one that illustrates the power of compounding. For example, if you started investing in the total U.S. stock market index in 1979 during President Jimmy Carter’s term and cashed out 40 years later in the middle of the Donald Trump presidency, you would have invested through three Democratic and four Republican presidents. You also would have experienced an 11.5% annualized return on your money. A single $10,000 investment would have turned into over $883,000 by the time of your retirement.6 One could parse a million statistics to highlight the relative economic benefit of one party over the other. However, the market will persevere, regardless of who’s in office. The key for all investors is to understand how their behavior is impacted by politics and implement strategies to overcome those biases.
Behavioral Finance
Understanding the field of behavioral finance can help explain why investors aren’t always rational, have limited self-control and are influenced by the way they view the world. The concept of heuristics, which is an individual’s tendency to take mental shortcuts to make quicker decisions, can help shed some light on this issue. Quick decisions are often plagued by emotions and natural biases, leading to errors in judgment. Recognizing and acknowledging these heuristics can allow investors to improve their decision-making processes and overcome these hurdles.
Two common heuristics that come up at the intersection of politics and investing are “confirmation bias” and “herd mentality.”
Confirmation bias: Confirmation bias is the fact that people are naturally drawn to consuming information that validates their own point of view, while simultaneously blocking out any data to the contrary. This happens independently in the world of politics and investing. The folks who watch CNN will generally never watch Fox News, and vice versa. Combining political views with the markets, and only selectively reviewing information that supports an investor’s opinion, is a sure way to lose money.
In the world of investing, it’s fine to look for supporting evidence for an investment thesis. However, it’s equally important to look for conflicting evidence that doesn’t support one’s position. Taking the time to deliberate over both supporting information and data that challenges one’s view is ultimately how good investment decisions are made.
Herd mentality: Herd mentality occurs when people want to be part of a community with a shared culture and socioeconomic norms. This can apply to being part of a team, place of worship or country club. A community will make decisions based on the shared points of view of its members, and many will share them publicly. These groupthink environments consequently lead to social pressures to conform. If someone’s herd is made up of politically like-minded individuals who express their investment philosophy in a particular way, there’s a high probability that the individual will express her investments in a similar vein.
How to Overcome Bias
It’s important to have systems and processes in place to overcome these heuristics and ensure investment decisions remain sound. The below items are essential in any fiduciary wealth management relationship and can help advisors and their clients stay the course.
Investment policy statement (IPS). A well-defined IPS is a wonderful way to clearly define a client’s objectives, keep the client on the same page as the advisor and put the client on track towards achieving her goals. While the standard IPS highlights a client’s financial goals, time horizon, risk tolerance, liquidity requirements, tax situation and income needs, it should also include any specific preferences that the client outlines. If the client is a politically charged individual, then laying out a specific framework for handling her investments during an election year is a judicious decision.
It’s not recommended to highlight specific investments to buy or sell based on the party that’s in office. Timing any investment based on the political climate is impossible and imprudent. A good illustration of why it’s a poor approach was the concern over health care stocks due to the enactment of the Affordable Care Act. Investors were worried that “ObamaCare,” as it’s become known, would destroy health care-related stocks across the industry. In reality, there ended up being mixed results with a variety of winners and losers in the space. For example, from when President Obama signed the bill on March 23, 2010 through the end of 2013, when the insurance exchanges were open, the top nine largest publicly traded health insurance companies and the 10 largest pharmaceutical companies achieved 96.8% and 51.5% total returns, respectively. This compared to a 52.2% return of the Dow Jones Industrial Average over the same time frame. However, the 10 largest medical device companies returned only 35.8%, drastically underperforming the other categories.7
A better approach is to put guardrails on one’s investments. As an example, if a client is concerned that a particular party is in office, instead of going to all cash, an IPS can give the client the flexibility to move a portion of her portfolio, say 10%, into cash. Alternatively, if the client is attracted to certain sectors of the market based on who’s in the White House, then the IPS should outline how large of a weighting the client is permitted to allocate to any specific sector. While this may not be the ideal way of investing, it satisfies the client’s emotional need to make decisions based on politics, without derailing her plan.
Automation. One sure way to eliminate the impact of emotional decisions is to build in a level of automation into one’s investment processes. The human element in any financial plan is crucial, but there are many processes that can successfully be automated to maintain impartiality and gain efficiency.
One type of automation is rebalancing, which is the process of adjusting the weightings of a portfolio as the investment values go up or down over time. When a portfolio is rebalanced, assets are bought or sold to maintain their original asset allocation, which is based on the investor’s risk tolerance. Investors can set their accounts to automatically rebalance at set dates throughout the year. Others may prefer for their portfolio to automatically rebalance once a position grows or shrinks beyond a certain predetermined percentage level. Regardless of the approach, the act of rebalancing has the benefit of preventing investors from letting their emotions determine when to purchase or sell existing positions.
Another automated process is setting up dollar-cost-averaging (DCA). DCA is the strategy of routinely adding money at regular intervals. The benefit is that it eliminates the desire to time when to enter the market. During both the 2012 and 2016 presidential elections, I had friends and colleagues move all their money to cash when their desired candidate didn’t win the presidency. They thought they could effectively time the opportune moment to take money out and ultimately to put money back into the markets. This turned out to be the wrong decision in both scenarios. DCA takes the urge of trying to time the market out of the equation. It’s set up effortlessly through a client’s IRC Section 401(k) plan at work and can be set up for a client’s taxable account by working with her financial advisor.
Diversification. Diversification is the concept of having exposure to various investments, such as stocks, bonds, commodities, real estate and alternative asset classes. It also means having exposure to various geographic locations, including outside of one’s home country. The beauty of always implementing portfolio diversification is that no asset class is 100% correlated with another. That means if stocks are down, bonds may be up. If one’s local market is struggling, other countries around the world may be thriving. Diversification is a powerful strategy because it allows investors to build wealth over the long term regardless of what’s happening in any one part of the market or who’s in the White House.
Advisor’s Role
A variety of factors, beyond just politics, may affect the movement of stock prices. These include: stock fundamentals, earnings, interest rates, labor growth, market sentiment, tax policy and geopolitical issues. To give any politician full credit for market performance, whether good or bad, seems disingenuous.
As the presidential election nears, it’s important to appreciate that the advisor drives the ultimate financial outcome far more than any politician. An advisor will speak to a client regularly to guide her through important issues such as cash flow management, prudent investments options, risk tolerance, time horizon, overall asset allocation, tax minimization and insurance coverage. The advisor will tweak the financial plan as life or the economic environment changes. Through it all, the advisor will also endeavor to prevent clients from making emotional decisions. In short, an advisor can help immunize a client’s portfolio from political bias and ensure the client is on track to achieve her financial objectives.
Endnotes
1. Mary Snow and Doug Schwartz, “All Top Dems Beat Trump As Voters’ Economic Outlook Dims Quinnipiac University Poll Finds; Dem Primary Stays Stable With Biden Holding The Lead,” Quinnipiac University Poll (Aug. 28, 2019), https://poll.qu.edu/national/release-detail?ReleaseID=3638.
2. Yosef Bonaparte, Alok Kumar and Jeremy K. Page, “Political climate, optimism, and investment decisions,” Journal of Financial Markets 34 (2017), at pp. 69-94, https://doi.org/10.1016/j.finmar.2017.05.002.
3. Luke DeVault and Richard Sias, “Hedge fund politics and portfolios,” Journal of Banking and Finance 75 (2017), at pp. 80-97, https://doi.org/10.1016/j.jbankfin.2016.10.011.
4. Jurrien Timmer, “Presidential Elections and Stock Returns,” Fidelity (Jan. 29, 2020), www.fidelity.com/learning-center/trading-investing/markets-sectors/stock-returns-and-elections.
5. Ibid.
6. Vanguard Mututal Funds, Vanguard Total Stock Market Index Fund Investor Shares, https://investor.vanguard.com/mutual-funds/profile/performance/vtsmx.
7. ProCon.org. Health Care Stocks: Performance under Obamacare (March 12, 2014), https://healthcarereform.procon.org/health-care-stocks-performance-under-obamacare/.