Today I want to address a question I have been getting a lot from clients and friends. This question is usually premised by a comment or concern sounding something like this, “I am worried that this election in November means that [FILL IN THE BLANK] will win the presidency and that will have a negative impact on markets… does this mean that I should sell my stocks?”
In order to answer this question, I need to take you on a little journey and give you a better understanding of how the stock market works.
So off we go…
Vegas Knows Something We Don’t Know
To start, I’d like you to imagine you were entered into a contest to win $1,000,000. Here are the rules of the competition: you need to guess the next champion (World Series, Super Bowl, Kentucky Derby, etc.) in a sport you know nothing about. You are allowed one resource to help you make your choice – you can’t phone a friend or Google your way to an answer – just one resource.
Here’s the question… what piece of information/resource would be the most helpful?
Let’s think through this together. If you asked to see last year’s results you could see how the competitors faired last season, but if you know sports, then you know this would not be very predictive of what will happen this season. If you requested a recent opinion piece from a top sports journalist about their predictions, it may be a bit better than knowing last year’s results, but you’d still be just gathering one person’s opinion. How about this, what if you requested the betting odds from the most popular gambling platform. This one resource would provide the collective wisdom of many participants and these would not be just willy-nilly guesses, these are people putting money on the line.
The betting odds would be your best resource in this competition. These wagers are leading indicators of what is believed to be the highest probability outcome.
The Wisdom of Crowds
Now, let’s express this same truth with another illustration.
In 1906 a statistician by the name of Sir Francis Galton became fascinated with a competition he stumbled upon at a livestock fair. Contestants had one simple task, to guess the weight of the ox – closest guess wins. As you could imagine, some guesses were grossly overestimated, and others swung the other way greatly underestimating the weight of the ox. Galton’s hypothesis was that if you were to take the average (mean) of all guesses then you would have the best estimate to the actual weight of the ox. Galton was absolutely correct; the average of all guesses was indeed the weight of the ox. Author James Surowiecki used this account from Galton to tee up his book aptly titled, The Wisdom of Crowds: Why the Many Are Smarter Than the Few and How Collective Wisdom Shapes Business, Economies, Societies, and Nations.
Again, the collective wisdom of the crowd provides the greatest predictive power.
A Leading Indicator
Next, let’s bring this back to our conversation about the stock market. Another example of a platform made up of a collection of participants seeking to make an accurate prediction. The stock market attempts to provide the most accurate price (valuation) of a business based on the most up-to-date information available.
If you were to open a finance textbook and began reading about the stock market, early on you would find a reference identifying the stock market as a leading indicator. This would be one of those terms that you would have to memorize for the test. The definition is simple, the stock market – reflecting the current valuations of publicly traded businesses – is a leading indicator of the health of the economy. If the stock market is trending positively it is assumed that future economic data will also reflect this positive trend and vice versa.
It’s important here to hone in on a key difference between reported economic data and the stock market. Economic data, like a job’s report or a GDP print, is providing you a snapshot of something that has already happened, while the price of the stock market is a prediction of what is assumed to happen.
Markets do a very good job of estimating these valuations because people have money on the line and the collective diligence of the participants strive to efficiently price every business. I would argue that markets are not perfectly efficient, but they are efficient. Much like investors are not perfectly rational, but they are rational.
Back to our Question…
Let’s recap.
We concluded that our preferred resource for our contest would be to know the sports betting odds. We learned that the average guess of all the fair patrons was the most accurate estimate for the ox. And we now know that the stock market is a mechanism for pricing in today what it believes about the future.
So, you have a gut feeling or an uneasiness about what may happen in November? Understandable. Perhaps this feeling is also rooted in the fact that the feared outcome doesn’t align with your own political beliefs. Again, understandable. Here’s my question though, what is the stock market doing today? It is currently attempting to price in – based on the collective wisdom of the crowd – what it believes will happen in November. There are countless resources out there from polling numbers to historical data that is feeding into the market’s conclusion about what will happen.
You are asking if your apprehension should lead you to change the make-up of your portfolio, but have you considered this – what if the outcome you are fearing is the outcome that the market already assumes will happen. Then the price of the market today already factors in your personal concerns.
I can answer this question even more directly. Do I believe it is wise for you to adjust your portfolio today to accounts for a one-time event in November of 2020 that you personally have concerns about? I do not. I think that your portfolio should be designed based on a financial plan that you and your advisor work diligently to solve for all of your long-term financial goals.
I will leave you with this one final tidbit, markets are disinterested in politics. The correlation between who is in office – republican or democrat – has no statistical significance to stock performance. Yes, what those politicians decide to do regarding taxes, regulations, etc. will have an effect on the businesses represented in the stock market, but that is what is great about America (1) we have a political system with multiple checks and balances that create a vetting mechanism for changes before they are implemented and (2) American business has proven to be resilient and acclimate to whatever environment it is presented with. I would encourage you to employ the energy fueling your concerns into the creation and implementation of your financial plan, which will have a greater impact on your long-term success.
This is TOM signing off…
