Many investors are preparing for a bumpy ride with the 2020 Presidential election approaching. Historical data suggests that the outcome of the election is not meaningful for stock market performance, but some trends like potential volatility are still worth noting for long-term investors looking to take advantage of opportunities.
Ultimately, it's important to avoid overreacting emotionally to the events of the coming months, and there are some tried and true methods to manage volatility if markets get bumpy.
How Presidential elections actually impact the stock market
Politically motivated observers are likely to forecast doom and gloom in the U.S. stock market if their preferred party happens to lose in November, but historical data shows that these party-specific fears are unfounded. Even ignoring the supposed impact that one candidate could have over the other, many strategists simply accept the assertion that volatility is heightened in election years. However, this assumption should also be tempered with a more nuanced look at historical results.
There is essentially no difference in stock market performance between the two major political parties over the full four-year term following a Presidential election. Republican winners have modestly outperformed Democrats in the first few years of their terms, on average, but the returns converge over a longer timeline. The clearest pattern that emerges across all data is that returns are actually much stronger in the final two years of a Presidential term than in the first two years. The magnitude of these relative returns depends on the index selected and how the study controls for major bull or bear markets that extend beyond a leader's time in office.
The relationship between elections and volatility is more complicated. It appears that volatility has actually been lower in the three months leading up to presidential elections than in other years, but November and December of election years tend to see more volatility. It would appear that the markets prioritize stability and that neither Democrats nor Republicans play a more prominent role in shaping long-term business fundamentals. Investors like incumbents, as there is a period of adjustment after a transfer of power takes place, and some time later, political influence takes a back seat to other economic factors.
Long-term investing is about fundamentals
Presidential elections are short-term, external events that dominate the news, but they ultimately only represent a small portion of the factors influencing stock market performance. Investors should not let political affiliations or sensational media influence their long-term positions. There may be heightened volatility following the election as some adjustments are made in the market, especially if the election results are contested. Luckily, these impacts should last for a few months to a year. Volatility is not a new challenge for investors, and there are a number of tested strategies to manage it.
Portfolio diversification is a sound principle that limits the downside risk posed by any one position in a portfolio, and it demonstrably reduces volatility. Similarly, an allocation that reduces correlation among holdings enhances the benefits of diversification. Dollar cost averaging (DCA) allows investors to further diversify across time. Common in retirement accounts, DCA involves dividing a lump sum investment into equal parts that are deployed at regular intervals over time into the market. This minimizes the likelihood of buying at a price peak, and it helps create a defined plan that is insulated from emotional decision making. Investors may also want to consider dividend stocks, which will provide returns in the form of cash flow to bridge any gaps during which the market is down.
Hedging with options is another strategy for more sophisticated investors. Buying put options is a popular way to protect against downside risk for long positions, but it requires a higher level of skill and familiarity with those financial products. Basically, a put option is a contract that gives the holder permission to sell a stock at an agreed-upon price at some point in the future. If a stock falls a certain amount, the option will lock in the lowest possible price for which a stock can sell.
Long-term value investors should create a plan and stick to it, making sure to avoid the pitfalls of emotional decisions. Historical data on Presidential elections shows us that the outcome will not have a major impact on index returns, and that any resulting volatility is likely to be short-lived. Adhering to tested principles to manage this volatility will set investors up for long-term success and open the door to opportunistic value identification along the way.