Investing in a Highly Politicized Climate

Investors have a lot on their minds these days, from trade negotiations to geopolitical tensions to a potential global economic slowdown and possible recession. There's also a U.S. presidential election on the horizon, adding political noise to investors' desire for clarity and understanding. Investor perceptions of risk and reward influence the decisions they make in their portfolios — and political leanings can distort these perceptions.

Politically inclined investors tend to see the markets as less risky and more attractive when their preferred party is in power. In contrast, those whose party is out of power are likely to feel more pessimistic and see greater risk in the markets.

In this age of information abundance, how should investors read and use the news for their benefit? Tune out the noise if you're looking for prudent guidance and actionable insights. Then, pay attention to the fundamentals, which have a bigger influence on market value than the fickle winds of the political climate.

Markets can turn volatile as investors shift their sentiments to align with their political inclinations. But like most external forces, these fluctuations have little long-term impact on the financial markets.

Political Tribalism: A Combustible Mix

Mark Twain once said, "Never talk about politics or religion in polite company." He could have added money to that list as well.

People tend to have strong feelings about both politics and money. There's nothing inherently wrong if someone holds strong political beliefs, but it's important to recognize the influence strong political views can have on different decisions we make, including how we invest money for the future.

This is a critical topic for financial advisors and investors to discuss because political tribalism — which is when people with strong political beliefs self-segregate into tribes of like-minded individuals — is at a high point right now. In fact, recent surveys by the Pew Research Center show that political tribalism is stronger now than it was 25 years ago. Around 45% of politically inclined people — both Democrats and Republicans — hold very unfavorable opinions of the other party.

Investing Under the Influence

The absence of diverse or challenging viewpoints can have an undue influence on investors who live inside these ideological bubbles. Loyalty to the "tribe" can distort their judgment and lead to emotional decisions that run counter to their personal investment objectives.

Research on the role of politics in investment decisions found that politically minded investors tend to be more optimistic about market opportunities when their preferred party is in power. As a result, they may take on more risk than they should and expose themselves to potential losses if the market falls.

Conversely, investors whose political party is out of power exhibit greater pessimism about the future. As a consequence, they may pull assets away from the market to lower their exposure to risk. But the greater risk these investors face is missing out on market gains.

Investors under the sway of political tribalism may see a connection between politics and investment that in reality does not exist. Market history shows that stock returns have been good under both Democratic and Republican presidents. Even one-party legislative control has had no discernible effect on market returns.

When politically minded investors connect electoral victories and market performance, confirmation bias is in full effect. For these investors, it can be affirming to believe their deeply held political views translate to financial gain. And politicians may try to link their policies with economic and financial success — it makes for memorable bumper stickers, rousing speeches and favorable headlines.

But the fact is, government policy or political control of different branches of government have negligible impacts on the direction of the financial markets. What drives market performance most of all is economic and business fundamentals.

Headlines vs. Fundamentals

When investment firms talk about "fundamentals," they're referring to the results achieved by businesses and the overall economy. Perhaps the most important business fundamental is earnings, because company earnings are the primary driver of equity market returns. When a firm can grow earnings, share profits with investors and reinvest in their business, the value of its equity shares tends to increase. Moreover, companies that deliver consistent earnings growth offer the best potential for long-term appreciation of their equity shares.

When gaps appear between equity prices and earnings, it reveals a market that's not fully efficient. In many cases, these periods of short-term equity volatility are event-driven — emotional reactions to news headlines.

It's not unusual to see declines within bull markets. During a long-term trend of growth, short-term volatility can create ideal opportunities to buy equities "on sale" when prices are discounted.

Investors can watch certain indicators for shifts in market or economic trends and prepare for the likelihood of a change in the cycle. For instance, the Index of Leading Economic Indicators (LEI) comprises several fundamental indicators that offers a one-look summary of economic performance. These indicators are important drivers of company performance — when these indicators show strength, it likely points toward positive corporate earnings, which in turn drive stock market returns.

Similarly, when these leading economic indicators are declining, it may show potential for worsening business conditions and subsequently a tougher climate for stock market returns.

How to Read the News Like a Savvy Investor

We're living in an age of information abundance. For an investor, that can be blessing; anyone with enough curiosity and time can unearth knowledge on any asset class or market trend under the sun. But the abundance of information can also be a curse. It's not unreasonable to say today's investors have too much information at their fingertips. While some of this information is valuable, a lot of it is simply "clickbait," designed to distract attention or provoke emotional reactions. In a sense, information abundance has turned into an information glut.

To sort through the information glut, investors must rely on their own judgment to extract the good data from the bad. That requires having some degree of trust in providers of information, as well as a healthy amount of self-awareness to recognize internal biases and to challenge existing beliefs.

When we look ahead to the next 12-18 months, we know some events are going to happen — the next presidential election on Nov. 3, 2020, for instance. We also know the current bull market for stocks will eventually end because bull markets don't go on forever. We just don't know when that will happen. What's important is for investors to focus on fundamentals and avoid the noise.

Key Takeaways

Investors should check any strong political biases when making decisions with investments or finances, remember that election results have very little impact on future investment returns, and stay focused on the fundamental drivers of investment performance — company earnings, sales revenue and other leading indicators — as they historically have had a greater impact on stock returns.

— Check out Religion and Politics Don't Mix With Investing on ThinkAdvisor.

Mark Hackett is chief of investment research at Nationwide.