Politics and Profits: Avoid your Biases
11/07/2017 5:00 am EST
Behaviorists cite a number of biases that influence our investment decisions; smart investors must recognize the dangers of investing with a political bias, asserts Chuck Carlson, editor of DRIP Investor.
Common biases include:
Confirmation bias: This occurs when investors are drawn to information that validates existing beliefs and ignore or devalue information that is contrary to those existing beliefs.
Loss aversion: Research indicates that investors often feel the pain from a loss more than the pleasure from gains. Loss aversion may cause investors to hold a losing position even though the best investment decision would be to sell and invest in a stock with better potential. Loss aversion may also cause investors to be overly conservative with their investments.
Recency bias: Individuals have a tendency to believe that what happens in the short term will continue indefinitely. Recency bias is a big reason investors chase short-term performance.
Another bias is political bias — the influence of an individual’s political persuasion on their investments. Type “politics,” “stock market,” and “2017” into Google search, and you get nearly 200 million results.
The huge number of results reflects what has become a national pastime with investors — and especially the media — analyzing the supposed link between politics and the stock market.
We say “supposed” because a rather strong argument can be made that there isn’t any link, or at least any link worth reflecting in an investment program.
Yes, I’m well aware of research that says that the stock market does better when a Democrat is in the Oval Office, and I am well aware of research that suggests the opposite.
One problem with these studies is that the outcomes are derived from very small sample sets. Since 1929, only 15 different individuals have held the presidency, eight Republicans and seven Democrats.
Furthermore, even if the stock market seems to do better during one party’s reign in the White House, the analysis would still suffer from “causation versus correlation” issues.
Is a higher stock market with a Democrat or Republican in the White House a result of that party in power? Or merely lucky timing, with the market’s movement driven by a host of other factors?
Researchers Sean Campbell and Canlin Li attempted to answer this question with a study that showed that neither risk nor return varies significantly across the presidential cycle.
In short, no conclusive evidence exists to suggest the president’s party has any statistically significant impact on U.S. equity market returns.
Now, some of you may be saying that your own experiences as an investor indicate the stock market is better when a Democrat or Republican is in the Oval Office, and you may be absolutely correct.
You may actually show better returns if your party of preference is running the country, and poorer returns when the opposition is in power.
But those portfolio returns may be more a function of how you invest depending on the party in power, and not the performance of the stock market.
A study conducted by researchers Yosef Bonaparte, Alok Kumar, and Jeremy Page entitled “Political Climate, Optimism, and Investment Decisions” showed that individuals become more optimistic and perceive the markets to be less risky and more undervalued when their own party is in power.
Specifically, when the political climate is aligned with their political identity, investors increase allocations to risky assets, such as high-beta, small-cap, and value stocks.
These investors also tend to trade less frequently, which reduces transaction costs. All of these moves improved raw portfolio performance.
Conversely, the tendency of investors is to be less optimistic when the opposition party is in power, which leads to reducing portfolio risk and increasing trading, factors that reduce expected returns.
Regardless of what side of the political spectrum you inhabit, you’d have to agree that we as a nation have become intensely polarized. With that intense political polarization comes strong biases infusing many aspects of our lives, including how we invest.
Smart investors recognize the dangers of investing with any biases and work to limit or even eliminate them from their investment programs.
Bottom line: If you want to maximize investment results, don’t structure your portfolio based on political biases. You’ll be distracted from focusing on what truly matters to long-term market returns — interest rates, inflation, and especially corporate profits. And your portfolio returns will likely suffer.