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Election Results Will Impact Investor Behavior Says School of Business Study

November 03, 2010
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Election KumarAs an investor, you approach the stock market unemotionally, always mindful to diversify your portfolio, invest for the long term and, if possible, buy low and sell high, right?  Not necessarily. Your feelings about the political climate and whether you favor the party “in power” have a significant impact on your investing, says a recent study from the School of Business finance department. In fact, given the changes that will result from the Nov. 2 midterm election, the research implies Democrats will make bigger investment mistakes and should be more cautious. On the other hand, Republicans are likely to make wiser investment decisions than those they made prior to the election.

In particular, if your preferred political party is in power, you are more likely to feel optimistic about financial markets and adjust your investment behavior correspondingly. That is according to research by the School’s Alok Kumar, Cesarano Scholar and professor of finance; Yosef Bonaparte, of Claremont McKenna College; and Jeremy Page, a doctoral student at the University of Texas at Austin.

The researchers looked at statistics from 1991 to 2002, during which Democrats and Republicans each took turns in office. They collected data from the UBS/Gallup Investor Optimism Survey, in which respondents indicate their political affiliation, and from a large discount brokerage house, in which case political preference was extrapolated based on ZIP codes and local voting patterns.

“We found that when investors’ preferred party was in control, they felt better about the economy and viewed domestic markets as undervalued and more likely to deliver higher returns,” said Kumar.  “This drove them to hold more domestic stocks and take more risks. Ultimately, their portfolios performed about 2.7 percent better than those of investors preferring the opposing party.”

In contrast, the study shows that when the preferred party was in the minority, investors perceived greater market uncertainty. As a consequence, they held more familiar, local stocks; picked active mutual funds with high fees; and traded more actively. Perhaps not surprisingly, based on their increased trading frequency, the performance of their portfolios suffered.

Kumar points out that these politically-driven behavioral biases prompt two different kinds of risk taking. One involves systematic risk, related to the overall macro economy, and the other involves idiosyncratic risk, related to a specific company. When investors’ preferred party was at the reins, they took more systematic risk, and the rewards were greater. When the preferred party was not in power, they took risks in just one stock or a few stocks, exposing themselves to high volatility.

The results were the same whether investors were Democrats or Republicans. They were also similar whether investors’ party of choice was only in the White House or had control of both the White House and Congress. Kumar says that he and his colleagues found some evidence that the effect was stronger among less sophisticated investors. The researchers focused on individual investors but they are currently developing a paper that measures the effect on institutional investors.

“The takeaway for those of us investing in the stock market is that share prices of companies held more by investors of one party than another may become misvalued when the opposing party is in power,” said Kumar. “The stocks of these companies will be traded more actively, so prices are likely to be further away from the fundamental. For example, research has shown that Republicans are more likely than Democrats to invest in industry sectors such as tobacco, firearms, defense, logging and mining.”

Kumar advises to use caution when the political regime shifts, especially if you have a strong political identity because when your preferred party loses, you are more likely to make investment mistakes.

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