Why Political Jitters Shouldn't Steer Your Investments

Midterm season just put a sharp lesson on display. The day after Democrats won control of both chambers of the legislature, the Dow jumped 3%, its best post-midterm day since 1982. The next day, stocks fell hard, and semiconductors dropped more than 12%, their worst day since the COVID-19 crash. Whiplash like that is exactly what makes political change feel dangerous for a portfolio.

Here's the thing, though: this kind of choppiness is normal around political contests. In 2020, stocks posted their worst week since the March sell-off in the week before the presidential contest, then their best week tied to a presidential race since 1932. In 2022's midterm cycle, stocks rose before the results, fell afterward, then rallied hard to finish the week. Nerves heading into the 2024 race also faded quickly, with the market staging a historically strong surge in the week after, second only to the 2020 rally.

In every one of those recent cases, the fear proved unsupported. And yet investors keep reacting as though this time will be different.

What the long-run record shows

Stocks were up at least 15% in the year after each of the last three presidential races. Looking further back, stocks have risen in the year after such contests nearly 75% of the time since 1928. Those odds don't guarantee anything, but they do tilt toward the idea that a positive year is more likely than not. U.S. stocks have also tended to rise regardless of which party holds the presidency or how Congress is split.

Sitting out the market while one party is in power has been a costly habit. Consider a hypothetical: $100 invested in the S&P 500 at the end of World War II grew to about $37,000 by the end of 2024. That same $100, invested only when a Republican president was in office, grew to roughly $1,000. Invested only under a Democratic president, it rose to about $4,000. Either way, investors who traded on party affiliation missed the bulk of the gains that came from simply staying invested. Index returns, of course, don't reflect fees, taxes or expenses, and nobody can buy an index directly.

That raises an obvious question. If there's little evidence that political change dismantles long-term bull markets, why do so many investors reshuffle their portfolios every time the political mood shifts?

Why fear wins the argument

Much of the volatility around political events comes down to fear of losses. Politics is good at triggering that fear. Leaders from both sides often claim their opponents will wreck the economy and that their own side will steer markets toward better returns. Challengers and newly empowered officials alike promise sweeping change, and some of those promises sound alarming to anyone holding stocks.

Psychology explains why those messages land so hard. Economists have shown that people hate losing money more than they enjoy gaining it. Daniel Kahneman and Amos Tversky's prospect theory, published in 1979, estimates that losses weigh on us roughly twice as heavily as equivalent gains. That asymmetry means investors can know the odds favor staying invested and still feel a strong pull to sell.

Worse, the feeling tends to peak at the wrong moment. Fear usually surges during the sharpest declines, which is when selling locks in losses that the market may later recover.

Three biases that push investors the wrong way

Recency bias is the first culprit. It makes us assume the latest move will continue indefinitely. A single steep drop or a few jumpy sessions can start to feel like the opening act of a crash. Market history, though, points the other way: high volatility tends to cluster around market bottoms rather than tops.

The availability heuristic is the second. Vivid, repeated headlines seem more important and more likely than they really are. When politicians keep warning that markets will collapse under their rivals, that message can feel like established fact simply because it's everywhere.

Herding is the third. People naturally assume the crowd knows something they don't, so they follow it.

All three were on display on November 5, when stocks tumbled. Trading volume hit 26.9 billion shares, well above the 20-day average of 17.7 billion, and decliners outnumbered advancers by more than 6 to 1. That's a crowd heading for the exit, acting as though the promises made on the campaign trail were about to become policy. Investors who joined the rush to sell often watched much of that damage reverse.

The gap between promises and outcomes is wide. Candidates pitch a long list of ideas, only some of them become policy, and the ones that do often arrive in a much diluted form. Building a portfolio around the assumption that every pre-contest promise will be enacted is a shaky foundation. That's especially true for midterm promises, since no single legislator controls whether a bill becomes law.

Watch the policy, not the noise

None of this means policy should be ignored. Actual legislation can affect specific sectors, earnings and the broader economy, and those effects are worth understanding. The political theater surrounding that legislation is a different matter.

Timing also matters. Selling around a midterm can mean stepping out right before what has historically been the strongest stretch of the four-year presidential cycle. Yale Hirsch, creator of the Stock Trader's Almanac, observed that the third year of a presidential term, the year after the midterm, has tended to be the strongest.

The numbers behind that observation are striking. Since 1931, third-year returns have averaged nearly 14%, compared with just over 6% in the other three years. The party mix hasn't broken that pattern. Third years under a Republican president with a divided Congress have averaged 23.1%, and those with a Democratic Congress have averaged 15.6%. Those samples are small, with just two and seven instances respectively, so they aren't a trading signal. They do, however, make a strong case against selling purely because control of Washington has shifted.

Sentiment can swing sharply around political events, but a sharp swing in sentiment isn't a reason to overhaul a long-term plan. Policy that truly changes the outlook for economic and earnings growth is a different story, and it's worth watching closely when it arrives.

For most households, the general lesson is simple: political outcomes are hard to predict, the emotional reaction is easy to predict, and history has repeatedly rewarded people who didn't let the second one drive the first. If you're weighing a change to your portfolio, a fee-only planner who knows your full financial picture can help you think it through.