Why Professional Investors Often Misjudge the Market After a Presidential Election

Professional investors often assume they are free of political bias. However, research suggests this is far from true. Political bias is proven to cost investors who may over- or under-estimate the state of the economy depending on whether their preferred party is in power.

In a Nasdaq article published in June, the investor Martin Tiller observed how many left-leaning investors dumped stocks after Donald Trump’s victory in 2016, as did right-leaning investors after Barack Obama’s victory in 2008, both motivated by notions that the wrong party had won the election and the economy would pay a price. Yet, the S&P 500 consistently grew in the months following each president’s inauguration, duping the investors who let their bias get in the way.

Academic research suggests this is a widespread phenomenon. A 2017 study in the Journal of Financial Markets highlighted how individuals’ investment behaviors shifted when their preferred political party held the White House. The study found that, when their favored party was in power, investors became more optimistic, perceived markets as less risky, and increased allocations to high-beta, small-cap, and value stocks. Consequently, nonpartisan investors consistently outperformed their Democratic- and Republican-leaning counterparts, according to a University of Chicago study of fund performance from 2015 to 2021.

Political bias affects not only market perspectives but also stock selection. Mutual fund managers often hold onto losing stocks issued by politically allied companies longer than justified, a behavioral pattern known as the “disposition effect,” according to a study by the University of Kansas of nearly 1,300 actively managed mutual funds between 2000 and 2015. In other words, fund managers may be overestimating the competence of companies led by executives who have similar political beliefs to theirs. The researchers found that funds with more politically-motivated stock selection have lower return-to-risk ratios.

Political bias isn’t confined to equity investors. A 2020 study tracking credit analysts from Fitch, Moody’s, and Standard & Poor’s between 2000 and 2018 showed that those not aligned with the sitting president’s party tended to issue more frequent downgrades of corporate credit ratings.

Nevertheless, historical market data provides a stark reality check. Long-term market performance has proven resilient regardless of which political party holds power. The S&P 500, for example, has typically risen regardless of partisan shifts in Washington.

While executive decisions from the White House can be large in scope and have long-term impact, markets are often able to work through them. For example, when Trump launched a trade war with China in September 2019, some analysts expected Apple (AAPL)’s iPhone sales to fall by as much as 8 million units and its share price to plummet. In the following 12 months, Apple’s stock rose 160 percent compared to the S&P 500’s 16 percent. Likewise, after President Biden’s inauguration, many expected his green energy policies would hurt oil and natural gas companies. And yet, Morningstar’s data finds U.S. energy companies outperformed the S&P 500 in the year following.

Political sentiments can also influence how major shareholders cast their votes on corporate policies. Major mutual funds and asset managers tend to vote in lockstep with the political party in control at the time, according to joint research from the City University of Hong Kong and INSEAD published in the International Banker. Examining shareholder voting behavior between 2004 and 2021, the researchers found major asset managers were substantially more likely to support environmental and social initiatives when a Democrat was in the White House than when a Republican was.

However, instead of bias getting in the way, another possible explanation is that major asset managers, like BlackRock (BLK), StateStreet and Vanguard, may be acting in accordance with the prevailing political party to avoid regulatory scrutiny. Further solidifying their findings, the researchers noted that voting behavior on corporate policies unrelated to environmental and social justice issues remained consistent, regardless of which political party was in power.

Data confirms that the stock market reflects investors’ election jitters. VIX, an index measuring volatility in the stock market, is about 6 percent higher during election years than in other years. A higher VIX reading signals increased expected volatility and heightened market uncertainty from investors.