How the presidential election could ruin your investment portfolio

During election seasons, financial markets are notoriously volatile and unpredictable as investors negotiate the potential for major policy changes and economic upheaval. Expectations for a new administration fuel a frenzy of speculation, causing market volatility that can unsettle even the most experienced investors. Election cycles have historically been characterized by more volatility. For example, during the 2016 presidential election, the Dow Jones Industrial Average fell by roughly 800 points overnight before recovering rather dramatically the next day. Similarly, the 2020 election campaign was rife with market volatility, reflecting great uncertainty about the outcome.

With new elections looming, investors especially need to know how political changes will affect their portfolios.

Historical Performance Analysis

A study of stock market behavior during past U.S. presidential elections reveals clear trends that often emerge around major events. Historical evidence shows that market volatility often increases in the months leading up to an election as uncertainty about the policies of the incoming administration creates a cautious investment environment.

For example, the S&P 500 fell significantly in the months leading up to the 2008 election, primarily in response to the global financial crisis but also due to uncertainty about the candidates’ crisis management strategies. Markets were initially volatile after the election but eventually settled down as the new government’s ideas began to take shape.

The 2016 election saw similar market volatility: the Dow Jones Industrial Average plummeted on election night as election results began to favor Donald Trump, but then recovered and surged a few days later as investors looked to business-friendly policies. The 2020 election also saw market volatility due to the COVID-19 pandemic, but ultimately the pandemic proved to be a positive one as investors responded to stimulus packages and vaccine progress.

Psychological impact on investors

The psychological impact of elections on traders and investors is enormous. Elections bring about great uncertainty and can lead to emotional and illogical behavior. Anxiety and fear of possible policy changes can lead investors to make hasty investment decisions or exit the market early, resulting in increased volatility.

For example, the unexpected outcome of the 2016 US presidential election triggered a tsunami of panic selling reflecting the initial shock to the market, but as analysts assessed the expected economic policies of the new administration, the market mood changed dramatically and a notable recovery occurred.

Similar trends have been observed in other large countries. One example is the Brexit vote that took place in the UK in 2016. The unexpected vote to leave the EU spooked investors and caused the FTSE 100 to plummet. The impact of Brexit was clear, and the market shifted and found a new stability over time.

Sectoral volatility and stability

Different sectors will react differently to the uncertainty and election outcomes, with some sectors showing more volatility and others showing more consistent reactions.

• health care: This industry can show large fluctuations during elections, especially when candidates propose major changes to healthcare policy. For example, healthcare stocks saw significant fluctuations during the 2020 election as investors considered the impact of the candidates’ differing healthcare policies.
• energy: The sector is highly sensitive to the outcome of the election, especially when it comes to policies regarding fossil fuels and renewable energy. Energy stocks, for example, have soared on hopes of pro-oil policies and deregulation from the Trump administration.
• technology: Historically, the technology industry has shown a fair amount of stability and resilience during election periods. Still, proposed policies such as data privacy and antitrust rules could impact the industry. Fears of increased regulation led to some volatility in technology stocks during the 2020 election.
• Finance: Financial stocks are highly sensitive to election outcomes, especially in response to legal changes. After the 2008 election, financial stocks initially fell due to the financial crisis, but eventually recovered as the new government implemented stabilization policies.

Election-related risk factors

Investors take on a variety of risks during election season that can have a significant impact on their portfolios.

One of the main dangers is policy uncertainty – uncertainty about future policy. A political campaign with competing ideas on the economy and regulation leaves investors questioning the policy direction of the next administration. This uncertainty can cause market volatility as investors try to predict and react to possible outcomes.

Another big danger is a changing regulatory environment. Political parties typically have different views on rules affecting sectors such as finance, healthcare, energy, and technology. For example, a government that favors deregulation could find that some regulatory protections benefit some industries while severely impacting others.

Elections can lead to significant shifts in government spending priorities. For example, cuts to healthcare spending could negatively impact the healthcare sector, while increased infrastructure spending under one administration could positively impact the construction and materials industries. The potential for these developments creates additional uncertainty for investors.

Impact of the election results

Different election outcomes could cause different degrees of market turmoil.

• Change of party: Markets typically react strongly when government power shifts between political parties with different economic philosophies. For example, a switch from a pro-business administration to one that emphasizes regulatory reform can create volatility in certain sectors. After the 2016 US elections handed out a Republican president and Congress, expected tax cuts and deregulation sent markets soaring.
• Unexpected election events: Markets are particularly sensitive to such events. One prominent example is the 2016 US presidential election. Market forecasts and opinion polls almost always predicted a different outcome than expected, but when the actual results deviated from these predictions, markets experienced immediate and major turmoil. Futures markets initially fell, but quickly recovered as investors considered the impact of the new government’s policies.
• Changes in the legislative balance: While the presidency remains with the same party, significant changes in the composition of Congress could affect market attitudes. For example, an evenly divided or opposition-dominated Congress could lead to parliamentary gridlock, affecting the implementation of economic policy and increasing uncertainty.

Strategic Investment Approach

Diversification is one of the best ways to mitigate the risks associated with market volatility due to elections. Investors can reduce their exposure to any one source of risk by spreading their investments across many asset classes, sectors and regions. This approach ensures that stability or gains in one area offset negative effects in another. For example, a well-diversified portfolio that includes technology, consumer staples and international markets can help offset the impact of potentially severe legislative changes on the healthcare industry.

Hedging is the use of financial instruments such as inverse ETFs, options, and futures to protect against possible losses. Buying put options allows investors to hedge their portfolios. If the underlying asset falls, the value of the put option increases. This approach provides a type of protection against a large market downturn caused by unexpected election results or changes in legislation. Additionally, inverse ETFs, which move inversely to the market, can help reduce downside risks.

In times of uncertainty, you can gain more stability by moving your assets into defense stocks and sectors. Defense industries, such as utilities, consumer staples, and healthcare, provide more stable financial performance and are therefore typically less vulnerable to political changes and economic cycles. Companies in these industries provide essential goods and services that are always in demand, regardless of the overall state of the economy.

Another smart strategy is to adjust your tactical asset allocation. Increasing your exposure to safe-haven assets like gold, government bonds, and premium corporate bonds can help counter market volatility during election season. Typically, these assets hold and even increase in value during times of uncertainty, helping to offset possible losses in a volatile stock market.

Finally, investors should maintain a long-term investment perspective during election periods. Reacting quickly to short-term market changes may lead to less-than-ideal investment choices. Instead, focusing on long-term principles and the expansionary potential of your investments will position you to benefit from post-election market shifts. Historically, after periods of political uncertainty, markets tend to recover and sustain an upward trend. Staying the course and avoiding knee-jerk trades will position investors to benefit from these longer-term trends.

Conclusion

Taken together, presidential elections historically bring about market volatility, policy uncertainty and increased sector-specific risks that can have a significant impact on investment portfolios. Further complicating the investment environment during election season is the psychological impact on investors and the potential for significant market shifts. However, strategic approaches such as diversification, hedging, shifting to defense industries and maintaining a long-term perspective can help mitigate these risks.

Investors should focus on informed strategic planning rather than running away from the crisis. Reviewing and modifying your investment plans will help you prepare for market shifts. Stay updated on political events and market reactions to ensure your portfolio is prepared for the uncertainty of the upcoming elections. Proactive and informed decision-making is needed to protect and potentially improve your investments during this turbulent time.