Which modern US presidential election has had the most significant impact on long-run asset class returns? I have no clue, but I am going to confidently tell you how financial markets will react to the upcoming one. Major events matter a great deal to investors even though history tells us that it is impossibly difficult to foresee their consequences, or indeed know whether they will matter at all over the long-term.

Ignorance would be bliss

The most obvious reason that noteworthy events, like presidential elections, are so diverting is that they are inescapable. We cannot help but have our attention drawn to them, and we consistently overweight the significance of things that are salient and available – that which is happening right in front of our eyes. To make matters more difficult, events like elections can have great importance in certain aspects of our lives, but not have much bearing on the long-term success of our investments. It is incredibly difficult to disentangle this – when an issue is relevant, we cannot help but think it is relevant everywhere and to everything.

It is also almost impossible for an investor to remain indifferent to a topic over which the asset management industry is obsessing. The fact that everyone has a forthright opinion on a subject bestows a significance upon it. We can join the party, or risk appearing negligent.

The threat of being labelled as inattentive to a profoundly consequential occurrence is exacerbated by the fact that – over the short-term – events like presidential elections will have an impact on financial markets. Many investors are involved in playing a game of predicting how other investors will react to a certain development: If x wins the election, then y sector will benefit – this type of behaviour is self-perpetuating. Markets move on events because investors expect markets to move on events. Although engaging in such speculative activity is unlikely to be beneficial, it does make doing nothing challenging – “you said elections were irrelevant, but look how markets have reacted”.

During such times it is easy to do things that are positive for how we are perceived, but negative for what we are trying to achieve.

Even if we are resolute enough to ignore the noisy, near-term ramifications of high-profile market events, surely they sometimes have longer-term consequences? It is possible, but requires us to predict profound structural changes in financial markets or economic conditions. It is far from easy to link an isolated past event to subsequent market performance – believing that we can do it for the future seems fanciful.

Complex problems

When we consider major events it is inevitably in a deterministic fashion. We believe that an event will precipitate a specific reaction, but that is not how complex systems work. They are chaotic and unpredictable. The result of one binary event (such as an election) could set us off on a million different paths, based on the disordered interactions of an incalculable number of variables. A deterministic approach makes us feel comfortable amidst substantial uncertainty, but it is in no way a reflection of reality. Investors might want it to be one way, but it is the other.

The best evidence of the challenge of making predictions around the financial market implications of events is how little time is spent reflecting on our previous forecasts. When a pundit spells out the consequences of the coming election result, how often do they inform us of their prior prescience around historic elections? On average, never. This is not just because they were probably wrong and that might inhibit our confidence in them, but because when we look back we will see quite how messy everything that followed was and how difficult it is to draw clear lines of causality. The US election is unlikely to be an epochal event that fundamentally changes the long-term financial market outlook (certainly not in a predictable way).

A common approach to simplifying the logic around how financial markets might behave around an election is to look at past instances of the same event. The problem of this – particularly when they are relatively rare – is that the sample size is inescapably miniscule, and each instance is influenced by a specific set of variables that were relevant only at that time. Confidently drawing inferences from such analysis is fraught with danger.     

Managing event risk

If engaging in speculation and prediction around the US election is unlikely to be prudent, what should investors do – just ignore it? Yes and no. Most investors with sensibly diversified portfolios haven’t really ignored this event or any others, they have instead used the principles of diversification when building their portfolios to reflect the fact that the future is inherently uncertain (and that includes event risk). A well-diversified portfolio is one which is robust to a range of different outcomes in financial markets – sufficiently resilient in the short-term to meet long-term goals. Unless we have a high conviction that the election materially changes the risk and return characteristics of key asset classes, our best approach is to do nothing and stay diversified.

When event risk is on the horizon, investors often gain comfort from running stress tests and scenario analysis on their portfolios, this can be problematic. As the saying (sort of) goes: all models are wrong, some are also useless. While it can – if framed with the appropriate context and caveats – be very helpful to understand the potential range of outcomes faced by a portfolio; tests that attempt to specify how asset classes will behave following a particular event are inevitably founded upon unrealistic and overconfident assumptions about the future. They can give us a false sense of certainty and should be handled with the utmost scepticism.

A stress test that would be beneficial for investors would be one that warns us of the type of poor decisions we are liable to make when under stress. These are the stresses that will have a predictable impact on portfolio outcomes.

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Significant events such as the US election present an acute challenge for investors. Sticking to our plans and admitting the limits to our knowledge amidst the maelstrom of pontification and prediction can seem almost impossible. Long-term, well-diversified investors should not despair, however, with a little fortitude it will pass away soon enough.

Until the next event.   

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My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).