40 Pages Posted: 21 Nov 2009 Last revised: 20 Apr 2012

Date Written: February 26, 2012

Abstract

We show that people's optimism towards financial markets and the macroeconomy is dynamically influenced by their political affiliation and the existing political climate. Individuals become more optimistic and perceive the markets to be less risky and more undervalued when their own party is in power. These shifts in perceptions of risk and reward affect investors' portfolio decisions. Specifically, when the political climate is aligned with their political identity, investors increase allocations to risky assets and exhibit a stronger preference for high market beta, small-cap, and value stocks. Due to these portfolio reallocations, investors improve their raw portfolio performance when their own party is in power, but the improvement in risk-adjusted performance is economically small.