When helping clients design an investment strategy, I often find it helpful to discuss two very different types of fundamental forces that determine whether stock markets go up or down.
The first, and most reliable, has to do with company profitability. Simply put, all other things being equal, companies that make more profits than anticipated by investors will see their stock price rise. The reverse is true for companies with profits that are lower than investors expected.
The second fundamental force driving stock markets is investor behavior. If people feel more confident, or see everyone else making money in the market and want to join the party, stocks will likely rise even when not supported by increased profits.
More often than not, stock markets do rise. Since 1928 the S&P 500 index of stock prices has risen during nearly 60% of the months, nearly 70% of the calendar years, over 85% of the 5-year periods, and nearly 95% of the ten-year periods.
Accordingly, anything that contributes to a person’s optimism is likely to correspond to increased participation in the market, which is likely to produce positive returns for that person. And the reverse is true for developments that make a person pessimistic about the future.
As another presidential election looms, it is worth considering how political developments might affect your behavior.
In 2012, some professors looked at this factor and determined that investors whose political party was in power performed measurably better each year than their counterparts. This was true for investors in both political parties.
The difference was not in the unique macro-economic policies of their favored party, but rather when the political climate was aligned with investors’ political identity, investors increased allocations to riskier assets, which on average, boosted their returns.
The lesson of the report is to think twice before allowing disappointment in elections to cause you to move out of higher-growth potential investments. The odds are high that if you are a long-term investor, such a move will compound your misery, complementing poor performance of your political party with poor performance in your investment portfolio.