Volatility Around Elections

If I had to take one thing away from my education on behavioral economics it is that humans aren't rational. This can be explained through Kahneman's heuristics or Keynes' human spirits, but generally, we don't function as Robinson Crusoe's. We have impulses and prescribe to herd mentality more often than not. Such behavior is particularly notable in financial markets around election time.

Without examining any data, I went into my questioning of this topic with a subconscious hypothesis in mind: markets have consistently elevated volatility throughout election cycles (before and after results are announced.) Such a hypothesis would make sense, given the uncertainty of the outcome of an election and the subsequent uncertainty surrounding the actions of a new candidate.

Surprisingly, such is not the case. In the last four election cycles, volatility (as measured by the CBOE VIX index, which measures the short term implied volatility of the S & P 500) invariably increases between October 1, and the two weeks before the election. Then, something fascinating happens: volatility drops off, meaning that investors see less future risk in investing in S&P 500 index funds and, more generally, see less short-term volatility in the entire economy.

Here, we can come back to our initial observation about irrational human behavior. Will the volatility a month from now realistically change that much in the two weeks before the election and the election itself? Probably not. Nevertheless, investors are human, and their decisions cannot always be explained. At the time of writing, this trend has played out yet again, and the VIX has seen a precipitous decline from a peak of around 23 over the last week.

Trends like this exist throughout the economy and serve as interesting manifestations of human's inexplicable decision-making.