The Problem with Reactionary Investing
As we all know, the United States just finished another round of elections, including the reelection of Barack Obama as president. The economy was a dominant issue in this election and many people have speculated about the impact either candidate would have on our economic recovery and the ominous federal deficit. Of particular interest to many people is what impact the candidates would have on the financial markets. This is a worthwhile question, but it seems people as intend to actually make investment decisions based on who the president is. I assert that this is a deeply flawed practice that extends well beyond who the president is.
News articles [1] and [2] from www.marketwatch.com both examine how the president’s anticipated policies and actions will help or hurt markets. They claim that among other things, The Patient Protection and Affordable Care Act will benefit drug makers, the Obama’s economic recovery policies benefit residential construction and real estate companies, and companies related to environmental regulations on energy production benefit from Obama’s tougher environmental positions. They think political gridlock will worsen and foreign affairs will degrade, leading to more quantitative easing and higher energy prices among other things. Based on this analysis, they provide several investment strategies. This includes increasing one’s positions in various energy, tech, and pharmaceutical companies such as United States Oil, Apple, and Alexion Pharmaceuticals.
News articles [3] and [4] from the NY Times and The Economist, respectively, talk about how there was a greater degree of certainty regarding who would win the presidency than the general media and public may have believed. In The Economist article, it states, “Nate Silver of the New York Times’s FiveThirtyEight blog, the best-known of the forecasters, currently gives Mr Obama an 86% chance to win. Sam Wang of the Princeton Election Consortium puts him at an even more generous 98%.” . It further claims that CA, OR, WA, NM, MN, IL, MI, PA, HI, DE, MD, DC, NJ, NY, VT, CT, RI, MA and ME (237 electoral college votes) were so solidly blue that Romney barely bothered to compete for them. Combined with leads in several other states, by the electoral college system, winning Ohio is the biggest hurdle to a second term for Obama and even if he loses Ohio he has so many other realistic options that he is bound to win. The NY Times article states, “Many executives resigned themselves weeks ago to four more years of Mr. Obama, conceding that much of Dodd-Frank was already baked into corporate strategy.” . It talks about how people in many industries have already been thinking about four more years of Obama will mean and trying to incorporate this into their strategy.
As discussed in A Random Walk Down Wallstreet [5], trying to pick stocks or other investments based on publicly available information cannot be successful according to the weak form of the efficient market hypothesis. Financial markets are perhaps the closest thing to a market in perfect competition. Everyone has a strong incentive to make what they think are the best investments. Also, this is a matching market where everyone knows what stocks have the greatest annual incomes, dividends, and volatility (This is computed from 10-Q and 10-K reports), but the stock prices adjust the values so that everyone should be indifferent between any publicly available investment. Since a good investment has to be not just a good asset, but a good value (ROI) for the asset, prices effectively even out the differences in performance. Moreover, to act on information and benefit from it before it is taken into account in prices, you need to be the first with the information. But, if you effectively just found that Obama will be the president for the next four years on November 6, then even the second these articles came out, you were unable to profit from this knowledge. Why? Because it is hard to say when people first decided that the odds of an Obama victory were large enough to act on. Even though the popular vote remained tight in polls leading up to the election, due to the electoral college, people in the know realized that Obama had an insanely high probability of winning. Information propagates through well connected networks at an exponential rate. Coupled with the communication speed of the internet age, it is futile to attempt to be the first with some information to exploit an arbitrage opportunity. This relates to how in matching markets we consider the pricing mechanism to be fully adjusted before connecting the two sides of the bipartite graph. Similar to a second price sealed bid auction, markets in perfect competition such as the stock market make the players effectively indifferent to the actions of everyone else. One cannot do better than investing in broad index funds over the entire market, no matter what, so the investment decisions of others become irrelevant.
[1] http://www.marketwatch.com/story/where-to-put-your-money-if-obama-wins-2012-11-06
[2] http://www.marketwatch.com/story/3-big-post-election-concerns-for-investors-2012-11-07
[3] http://www.nytimes.com/interactive/2012/11/07/business/industry-reactions-to-election.html?hp#/#finance
[4] http://www.economist.com/blogs/democracyinamerica/2012/11/presidential-race-0
[5] http://www.amazon.com/Random-Walk-Down-Wall-Street/dp/0393340740/ref=pd_sim_b_1
12345