Why You Shouldn’t Let Political Dread Dictate Your Portfolio

The midterm election season has delivered a live demonstration of the market volatility that can emerge when investors trade elections.

The day after Democrats won control of both the House and Senate, the Dow jumped 3%, its best post-midterm day since 1982. A day later, stocks plummeted, and semiconductors plunged more than 12%, their worst day since the COVID-19 crash.

The volatility playing out in markets is not particularly abnormal, for election seasons are often erratic. In 2020, stocks posted their worst week since the March sell-off of that year the week before the election, then their best election week since 1932.

In 2022's midterm season, stocks rose before the vote, plummeted after, then rallied hard to end the week. Stocks nerves going into the 2024 election also proved fleeting, with the market staging a historically strong surge second only to the 2020 rally in the week after the election.

Investors appear to be once again falling into what has become a common pattern of allowing politics to spook their portfolio strategy, despite the fact that in all of those recent cases, investor nerves around elections proved unsupported.

A positive outlook

Stocks were up at least 15% in the year after each of the last three elections. Probabilities favor a positive outlook in general — stocks have risen in the year after elections nearly 75% of the time since 1928. Likewise, U.S. stocks tend to rise regardless of which party holds the White House or how Congress is split.

History shows sitting out of the market while one party or the other is in power is an irrational strategy, yet investors seem continually compelled to base portfolio decisions on politics.

By the end of 2024, $100 invested in the S&P 500 at the end of WWII grew to about $37,000, but if that same $100 was invested only when a Republican president was in the White House, it grew to merely $1,000. If invested only when a Democrat led the country, it rose to just $4,000.

Either way, partisan investors would have missed out on an enormous gain by investing based on politics rather than simply staying the course.

Thus, it is worth asking the question: Why, given a lack of evidence to support the notion that political change will somehow dismantle bull markets in stocks, do investors shift portfolios so much around elections?

Why elections make us want to sell stocks

The unusual volatility around elections can be largely explained by investors' fear that losses may emerge from political change. There is no evidence to support the notion that politics determine returns, but unfortunately, politics can trigger fears that often overwhelm facts and directly impact investing behavior.

Republicans and Democrats alike suggest they will shepherd markets toward better returns while the opposing party is doomed to fail, creating a fear of losses in the investing public.

Politicians, particularly those in the party that opposes the one in power, also promise an immense amount of change ahead, some of which sparks additional fear of losses.

Humans are extremely averse to loss, and the fear of it creates irrational investing behavior. Economists have shown that we hate losing money even more than we like gaining it.

We irrationally weigh our fear of loss more heavily than our desire for gains, and even though the probabilities favor staying invested, we often look to sell. This "loss aversion" is a cornerstone of Daniel Kahneman and Amos Tversky's prospect theory, which estimates that losses weigh on us roughly twice as much as equivalent gains.

Worse, other behavioral biases make us prone to selling at precisely the wrong time — in the midst of the market's relatively unusual declining phases.

The behavioral mistakes that emerge

Election weeks are a perfect storm for behavioral mistakes like recency bias, which leads us to project the latest move far into the future. One large drop or a series of volatile days starts to feel like the beginning of a crash.

Intriguingly, market history shows the opposite is more likely. High volatility tends to cluster around bottoms in equities rather than at tops.

Likewise, the availability heuristic makes vivid, constantly repeated news seem more important and more likely than it really is. Thus, when politicians repeat the message that markets are doomed under the leadership of their adversaries, investors can't help but think it true.

Finally, herding pulls us toward doing what everyone else seems to be doing. We naturally assume the crowd knows more than we do.

All of these behavioral biases were on display when stocks tanked on November 5. Trading volume hit 26.9 billion shares, well above the 20-day average of 17.7 billion, and decliners outnumbered advancers by more than 6 to 1.

That is the very definition of a crowd heading for the exit, presuming political promises were likely to become policy reality. Investors who followed the herd sold into the panic, only to subsequently see much of the damage reversed.

Politicians campaign on a dizzying number of ideas that only sometimes become policy realities, and the policies that ultimately do emerge from political change usually emerge in highly diluted form.

As a result, positioning a portfolio on the idea that campaign promises will become policies can be fraught with peril. This is an especially poignant point to consider when assessing the policy potential of promises made during midterm political races, given no single member of Congress controls whether a bill is signed into law.

Actual policy is important to understand and assess for its potential impact on portfolios. Politics are not.

Tune out the noise, stay with the plan, watch the policies

While political promises may indeed become policy realities in the year ahead, the bar for selling stocks at this point in the cycle is particularly high. Selling around a midterm can mean stepping out right before the best part of the four-year presidential cycle.

Yale Hirsch, creator of the Stock Trader's Almanac, observed that the third year of a presidential term, the year after the midterm, tends to be the strongest.

Since 1931, third-year returns have averaged nearly 14%, vs just over 6% in the other three years. The party mix hasn't spoiled that pattern. A Republican president with a mixed Congress has averaged 23.1% in year three and, with a Democratic Congress, 15.6%.

Those samples are small (two and seven instances), so they are no trading signal. But they argue strongly against the instinct to sell purely because of a change in party mix in Washington.

Election cycles are exciting times for citizens of democracies, but they are also emotionally charged, and they breed irrational behavior among investors.

Sentiment toward the economy and markets can shift dramatically with elections, but it should not spark a dramatic shift in portfolio strategy unless politics become policies that truly start to impact the outlook for economic and earnings growth.

The disciplined path is simple: Stay invested, judge policies by their effect on earnings and the economy and resist the urge to act on fear of political change.

Don't let politics haunt your portfolio.

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This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.