Decision economics: don't let election fears obscure your long-term goals

Well, history will give you almost any answer you like if you torture the data enough. And, if you listen to your preferred news network, you’re likely to hear the answer you seek (and are already predisposed to believe).

The reality is that elections come and go and things don’t tend to change too much. The status quo normally prevails. The world will continue to turn, Apple will continue to make smartphones, and the Nordic regions will continue to consume the most coffee per capita.

That’s not to say that elections don’t have consequences—they do. But is worrying about the outcome going to change anything? And is changing your portfolio going to improve your ability to reach your long-term goals?

This election arrives hot on the heels of the global pandemic, which resulted in a surge in volatility and a more than 30% decline in the S&P 500 Index.¹ The suddenness of the meltdown and speed of recovery caught most off guard—leading many to do nothing as it relates to their portfolio. In retrospect, that was wise for most investors as markets have largely recovered their losses, and selling at the bottom would’ve been a colossal mistake.

But the election has a known date and the media is revving up with its predictions about what the potential outcomes could mean for your pocketbook and your portfolio. Suffice to say that good news doesn’t grab your attention, but dire predictions might. Daniel Kahneman, Nobel prize winner for prospect theory, found that investors experience the pain of loss at two to three times the intensity as the euphoria of gains.²  That asymmetry runs counter to standard finance theory, which states that investors should be largely indifferent to losses and gains in the short term as long as the expected return of the investment meets their long-term goals.

However, researchers and neurologists have also established a physiological link between the brain’s fight or flight response and how we process investment losses.³ When danger is detected, a specific region of the brain releases adrenaline, which focuses attention and puts the body on high alert. The goal of this hardwired response is immediate safety from harm. From that perspective, you should expect most of the election-related advice coming from news sources to be geared toward triggering an emotional reaction in you that’s both conscious and subconscious and not necessarily in your best interests from a long-term perspective.

Retail investors would be wise to take a page from the institutional playbook. A major difference between retail and institutional investors is how they assess risk and build portfolios. With retail investors, we ask questions surrounding their tolerance regarding losses in the short term. If the client has a low tolerance for losses, we build a lower-risk portfolio. This preference-based approach to portfolio construction is the exact opposite of the way many institutional investors build portfolios. With pension plans, for example, the funding need (the plan’s future liability) dictates the amount of risk they need to assume. In other words, the short-term need for safety is irrelevant to the pension plan manager and doesn’t drive decision-making in any material way. Herein lies the challenge for the financial professional serving the retail investor: getting them to separate their preference for short-term safety from their capacity (i.e., need) to take risks for the benefit of their long-term security. 

PAUSE is a technique introduced in an earlier viewpoint  that’s effective at shifting the investor’s thinking from a short-term, emotion-based mindset to a longer-term, logic-based mindset. It relies on reframing the investor’s concerns in a way that gets them to see the illogic of their thinking without causing offense. Below is an example that might apply to a client who calls with concerns about the upcoming election cycle and the potential impact on their portfolio.

Developing the ability to shift an investor’s mode of thinking from an emotional short-term reaction to a more logical, long-term focused outlook is a critically important skill that the financial professional brings to the relationship. Using PAUSE can encourage clients to think rationally about their investment decisions regardless of who wins come November. Helping investors see the difference between what’s plausible versus what’s probable can be invaluable for the success of their long-term financial goals.

The John Hancock Investment Consulting Group is here to help. They offer a range of services, from formal model reviews to manager selection and building an investment decision process. For more information, contact us today.

1 S&P 500 Index, as of August 31, 2020, 2 Prospect theory, behavioural economics.com, 3 "Op-Ed: Don't let coronavirus market swings hijack your brain," Stacy Frances, CNBC, April 15, 2020.