Research shows that investors’ political leanings can influence their sentiments on the state of the markets and economy – and potentially lead them to make irrational decisions about how to position their portfolios. Retirement and wealth strategies expert Matt Sommer discusses how financial professionals can help mitigate this behavior through validation and education.
A 2017 study investigated the relationship between individual political affiliations and shifts in optimism and investment decisions. The findings revealed that individuals become more optimistic about the stock market and overall economy when their preferred political party is in power. Furthermore, investors showed a preference for stocks with higher market beta as well as riskier small-cap and value styles when the political environment is aligned with their own political identity.1
Many financial professionals have likely experienced this bias firsthand since the November election results. Clients who are happy with the outcome may have turned bullish on the markets and economy while those who are unhappy may have lost confidence. If left unchecked, this bias can lead investors to assume market risk that is not necessarily aligned with their risk tolerance.
Validate, then Educate
Clearly, abruptly changing course because you don’t like the results of the most recent election is not a good recipe for long-term investing success. The challenge for financial professionals is how to help mitigate political bias so it doesn’t adversely impact clients’ investment decisions. Just like any other behavioral finance trap that causes investors to make irrational decisions, political bias is best addressed through education and reason.
The most important thing to remember is that political bias is an emotional reaction – not a cognitive error. A client who is feeling confident and optimistic may be very excited about putting more money into the market and potentially taking on more risk than they would normally be comfortable with – and more than their long-term investment objectives would dictate is appropriate. Before we attempt to educate or reason with a client who is experiencing this emotional response, it is critical that we first validate their reaction and hear what they have to say.
Once we validate that feeling – which can be done simply by not attempting to argue with or correct it – the study referenced above could serve as a talking point to get the conversation started. For example, we could say something like, “It’s funny you should say that because some recent research found there are a lot of people that are having an emotional reaction to what’s happening in Washington.”
This approach works in two ways: It helps the client see that other people are feeling the same way, and it substantiates the fact that this is an emotional reaction via objective, third-party research – which helps us steer clear of directly judging or labeling what the client is experiencing.
Time for a History Lesson
Once we have validated the client’s emotions, the education conversation should be much easier and better received. And the good news is, the most effective lesson is no different from the one we tell our clients through all periods of volatility and uncertainty. It’s reminding them that, throughout the history of the stock market, there have been ups and downs, and staying the course has generally resulted in a better outcome than trying to time the market. This can be easily illustrated through historical data: facts that are tough to argue with.
For investors who harbor the notion that markets perform better under their preferred political party, my colleague Ben Rizzuto offered some compelling data showing that there is no clear answer to the question of whether a Democratic or Republican president is better for the stock market. Over time, the differences are simply not significant enough to draw a definitive conclusion.
Mitigating political bias in investing is just one of the topics I cover in this year’s edition of our Essentials of Wealth Planning Guide, Lessons Learned from Pandemics, Elections and Murder Hornets. I hope you will explore the rest of the guide to learn about some of the other key trends that could impact your most-valued clients in the year ahead.
1Bonaparte, Y., Kumar, A.. & Page, J. (2017). Political climate, optimism, and investment decisions. Journal of Financial Markets, 34, 69-94.