Vote through the ballot box, not through your wallet.
Keeping politics and money separate is easier said than done. Every election cycle, investors let their political affiliations dictate where they put their money. According to Tom McLoughlin, head of fixed income at UBS, investors tend to de-risk their portfolios by moving out of equities when their preferred candidate doesn’t win.
This is a serious mistake that is costing investors dearly – by up to 57% over a period of two decades. Here’s the psychology behind this behaviour and how to best avoid it.
Blue and red glasses
Political affiliations create biases that cloud investors’ interpretations of the economy and ultimately lead to suboptimal investment decisions.
As the chart below shows, Americans generally have more confidence in the economy when their preferred party is in the White House.
UBS
Comparing Republican and Democratic consumer sentiment using the University of Michigan’s Consumer Sentiment Index, it’s clear that Republicans had a much more positive view of the economy under Trump than under Biden, and vice versa.
Another aspect of this phenomenon, called “negative partisanship,” is the fact that investors harbor much stronger negative feelings toward the opposing political party than positive feelings toward their own. This is similar to the concept of loss aversion in behavioral finance, where losing money creates stronger psychological discomfort than a comparable gain.
Just as loss aversion can lead investors to make irrational decisions to avoid feeling the pain of a loss, negative partisanship can cloud investors’ judgment and cause them to overreact to undesirable political outcomes.
“It’s very common for investors to react to an election result they don’t like,” McLoughlin said. “There’s a tendency to not take risks and reduce concentration in stocks, which over a longer period will basically reduce returns.”
The price of partisanship
How much does it cost investors to be partisan? UBS conducted an analysis using Consumer Confidence Index data from September 2006 through May 2024 and found that by reducing stock concentration in response to unfavorable election results, investors reduced their cumulative returns by 57% over that 18-year period.
The bank assumed that investors held a portfolio of 60% stocks and 40% bonds when they felt neutral or optimistic about the economy. When investors’ consumer confidence fell to the lowest quartile of the Consumer Confidence Index, UBS assumed that investors held a portfolio of 40% stocks and 60% bonds.
According to this model, a bearish investor who bought more bonds after Trump’s election would have missed the stock market rally following the 2017 tax cuts. Similarly, investors pessimistic about a Biden presidency would have missed the post-pandemic market rally of the past two years.
Under these circumstances, an investor who had traded and held his shares would have made a cumulative return of 356% since 2006, but an investor who had traded based on the consumer sentiment of the out-of-power party would have made only a return of 299% over the same time period.
How to avoid the partisan trap
This phenomenon is not limited to individual investors. “Professional and institutional investors are just as susceptible to this phenomenon as our private clients, which is quite interesting. It’s something that most institutional investors should be able to resist, and usually don’t,” McLoughlin said.
The most important thing when investing during an election period is to stay calm. “What we’ve suggested to clients is to take a pause,” says McLoughlin. “Regardless of the outcome, don’t abandon the individual financial plans you’ve worked out with your financial adviser.”
As November approaches, investors should take a long-term mindset and keep in mind that while the US election is an important event, it is not the most influential factor in the broader global economy. Even in the case of the US, the extent of domestic policy change depends largely on the composition of Congress.
In the stock market, some industries will inevitably be more sensitive to the party in the White House. However, a well-diversified portfolio is the best strategy to deal with election risk, not constant trading and rebalancing. UBS recommends investing in a mix of financial services stocks and gold to best hedge election risk.
