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As political divides widen in Western countries, voters’ views are increasingly shaping decisions beyond elections — from wearing a mask during the Covid-19 pandemic to eating food or driving a car. Recent research shows that political preferences have also become an important determinant of how individuals invest, with significant economic consequences.
Researchers from MIT have shown that investors’ economic prospects are colored by their political views. They have also discovered that their willingness to take financial risks depends on the extent to which their views align with those of the government. For example, during Trump’s presidency, Republicans were more optimistic about the future of the American economy than Democrats. Such different expectations caused Republicans to become more optimistic and hold more stocks in their portfolios, compared to less risky cash or bonds.
Us ongoing work with Yihui Pan, Elena Pikulina and Tracy Wang show that even the composition of investors’ shareholdings differs depending on political views. We examined the investments made over the past 25 years by wealthy American households, who likely differ in their political orientation. Although such differences have not played a role in portfolio composition for a long time, they have emerged as an important determining factor over the past decade.
To distinguish between correlation and causality, we examined the entry of Sinclair, a conservative TV network, into local media markets. Its arrival is not only associated with an increase in the number of local Republican votes in a region, but also appears to change the composition of local stock portfolios.
The politically driven differences in the way Americans invest are striking and stand in stark contrast to the overall convergence of portfolio composition you might expect, given the benefits of diversification and the low costs of index-based investing. It raises the question of what causes this difference and what the consequences could be.
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Although the causes seem multifaceted, a combination of two forces offers a plausible explanation: political preferences increasingly determine norms and values, and values increasingly influence investment decisions, for example through ESG investing.
Recent sociological research shows that the role of political affiliation in shaping values has increased significantly in recent years – but the role of income, race, gender and whether people live in urban areas has largely remained the same or even declined.
At the same time, values-based investing is on the rise. Today, even financial advisors targeting wealthy Americans with an average $1 million account commonly offer investment restrictions and exclusions based on social and environmental considerations, even as the monetary and non-monetary promises of value-based portfolios remain questionable.
Research on the share of investment in companies with environmental or labor concerns, and that of small firearms manufacturers and distributors, indicates a clear pattern. Among wealthy households with financial advisors, those more likely to be Democrats are significantly underweight such firms. Meanwhile, investors, who are more likely to lean toward Republicans, appear to be underweight companies led by Democratic executives.
Politically motivated portfolio segmentation has several potential implications. First, risk sharing in the economy could decline as political preferences lead to under- or overweighting of certain companies, industries, or sectors.
Second, companies and investors will need to be aware of the non-financial preferences of their potential shareholders. For example, when US groups were required to disclose the ratio of executive pay to average employee pay for the first time in 2018, the market’s response to companies with the largest gaps was: considerably more negative including democratic and inequality-averse shareholders. These investors were more likely to rebalance their portfolios away from such companies.
Finally, politically induced differences in portfolios could further deepen the divide in society if investors vote according to their economic interests. So, for example, while political preferences may lead to investments in “green” companies and technologies, they in turn create an economic incentive in favor of certain policies and political preferences – creating a feedback loop between political and economic interests.
It therefore appears that broad diversification in the form of ‘holding the market’ could not only be good investment advice, but could also help counter the increasing political polarization of society.
Stephan Siegel is Michael G. Foster Endowed Professor of Finance & Business Economics at the Michael G. Foster School of Business, University of Washington, Seattle