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Political heterogeneity, subjective optimism, and stock market outcomes

ABSTRACT We demonstrate that political heterogeneity, proxied by the spread in subjective optimism between Democratic and Republican investors, affects stock market returns and volatility. Our intuition, drawn from the psychology literature on intergroup conflict, leads us to infer that increased political heterogeneity causes investors to become entrenched, not just in their political beliefs, but also in their economic outlook. Consequently, they become resistant to contrary news, and this behaviour is linked to lower market volatility and higher market returns. These findings are further underpinned by evidence that shows idiosyncratic volatility, which reflects the level of stock responses to firm-specific information, to decrease as political heterogeneity increases.