As an investor you should know that the market doesn’t really care which party or person wins an election. There’s money to make either way.
But that doesn’t mean that the outcome of elections don’t have consequences for portfolios. The result of an election can have a significant impact on local, regional, or national monetary policy particularly as it relates to taxes and regulation. Elections also have a way of clarifying sectors that will be leaders and those that will be laggards.
However, some investors look at an election year as a reason to avoid the market. In this article, we’ll look at the psychology behind investing in election years, whether investors are better investing in large cap or small-cap stocks and why the best action may be to simply continue doing what you’re doing.
Elections Create Uncertainty
Markets aren’t as predictable as many investors would like to believe. However, election years add a layer of uncertainty that can add volatility to the markets. But how much does that really affect an investor’s total return?
The answer may surprise you. In non-election years, the S&P 500 price index has an average return of 9.6%. In an election year, that number is about 5.6%. And history shows that in a presidential election year, the vast majority of those gains occur in the last two months of the year.
The reason is that the result of an election, no matter how it turns out brings clarity to the market. As we pointed out above, there’s money to be made no matter how the election turns out. The outcome is a signal to investors on where they are likely to get the best return.
Small-Cap Stocks May Surprise investors
Small-cap stocks tend to closely approximate the performance of large-cap stocks during an election year. In fact, because they tend to be high beta stocks, small-cap stocks have a tendency to outperform large cap stocks in the months after an election. In general a stock with a high beta value will have a more dramatic move to the upside when sentiment is positive and to the downside when sentiment is negative.
How do Stocks Perform the Year After an Election?
Continuing with the theme that investors like certainty, both large cap and small-cap stocks historically perform well in the year after an election. This may be due largely to the fact that it’s a time when legislation moves through Congress that reflects the platform of the newly elected officials.
Hail to the Chief, Any Chief
There is some evidence that the stock market generally performs better under a Republican administration. However, viewed from a longer lens, the average return under any president going back to the Hoover administration is approximately 10%.
Take Emotion Out of It
Elections stir the passion of voters. And when those voters are investors it can have negative effect on a portfolio. Making the decision to get out of stocks because you don’t like the result of an election is not a prudent strategy.
For example, Barack Obama was elected in 2008 near the trough of the financial crisis. If investors stayed on the sidelines they would have missed out on the beginning of the longest bull market in history.
In fact, in the first four years of the Obama administration an investment in an S&P 500 index fund would have returned 148%. And as any investor will tell you, it’s the period immediately after market sentiment changes when the biggest gains are made.
Another example of emotions getting in the way of portfolio gains occurred with the election of Donald Trump in 2020. Many investors pulled out of the market expecting that the economy would take a downturn. Once again, those investors would have missed out on strong market growth. Once again an investment in an S&P index fund between November 2020 and January 1, 2018 would have returned approximately 28%.
Sector Allocation is Essential
As we noted above, elections have consequences. And those consequences are frequently seen in the macroeconomic shifts that they can promote. Consider these examples:
- In 2004, defense stocks rose sharply as the re-election of George W. Bush ensured that the United States would be continuing its foreign policy in Iraq and Afghanistan.
- In 2008 health care stocks surged with the election of Barack Obama who ran on a platform of providing universal health care for all Americans.
- In 2020, electric vehicle stocks moved higher after the election of Joe Biden who campaigned for the reduction of fossil fuels.
Because of the volatility that occurs in election years, it can be difficult to pick out the stocks within each sector that will benefit. Investors may benefit from using exchange-traded funds (ETFs) or mutual funds that specialize in certain sectors as a proxy for investing in a sector. These funds are an ideal way for investors to get exposure to a sector while limiting their exposure to any individual stock.
Over Time Stocks Generally Rise no Matter What the Result
What I hope you’re taking away from this article is that elections may have a significant impact on your personal finances. But over time, they generally have less effect on your investments.
That doesn’t mean your portfolio will always move in a positive direction. Decisions made by elected officials can have profound impacts (good and bad) on the broader economy. But over time, investors who have been in the market understand that the market has always trended higher.
Here are a few tips to help you keep a long-term perspective:
Keep Your Goals in Mind – You started investing for a reason. If you still have a long time until you will need your income from your investments, staying invested will keep you on track to reaching your goals. It may feel safer on the sidelines, but market timing is not a successful strategy for most investors. And you have to consider how you’ll feel if you would have just stayed in the market for a few months longer.
Plan For a Range of Outcomes – It’s always sound advice to hope for the best and plan for the worst. No investor should take a “set it and forget it” approach to investing. Even the most committed buy-and-hold investor should check in with their portfolio from time to time to ensure that they are maximizing their gains. As noted above, elections can provide clarity and that clarity may challenge some assumptions.
You Can’t Predict the Future – Many elected officials, particularly presidents, can point to examples of where campaign promises got derailed for external events that were out of their control and could not have been foreseen. That means that it’s best for investors to realize that the person who gets elected may have less control over your portfolio than you think. The best strategy is to continue to build a diversified portfolio.
Some Final Thoughts on Investing in Election Years
In the final analysis, the trend has been the friend of investors. And viewed with a long-term lens, investing in quality stocks has been a reliable way to build wealth.
That being said, the uncertainty that occurs in an election year can add volatility in an election year. But over time, stocks tend to climb after an election no matter which party assumes power. And that generally has a halo effect that carries into the following year.
However, when investing in an election year, investors may still want to take prudent steps to manage the uncertainty. For example, if they are overexposed to a sector that is likely to fall out of favor with a new administration, this may be the time to take profits and reallocate those assets to more favorable sectors.
You should also take your emotions out of it. Your investment goals are all that matter. If you’re an investor with a lower risk tolerance investing in dividend-paying blue-chip stocks may be a desirable alternative. These stocks tend to be stable performers no matter what is happening in the broader economy.