Should I buy BP?

As a professor and a registered investment advisor I can’t count the number of times I’ve been asked the question, “Should I buy BP?” over recent weeks. 

 

As usual, my answer is, “It depends”, as it depends on a lot of factors: the questioner’s preference toward risk, their total portfolio of assets and their need for income, their desire to be a “green” investor, among other things.  It is difficult, as well as inappropriate, for an advisor to provide an answer to this question, without performing the due diligence required to understand the investor’s goals, their resources, their level of diversification, and the total family’s preferences.  Yet, I am continually amazed at how many of us remain eager to invest in new ideas, new “opportunities”, with little regard for what we do know about investments.  The most important thing we know about investments is diversification.

 

I recently came across a website assetcorrelation.com which provides visual aids to help investors focus on what I believe to be the principles of sound investing: discipline, diversification, and time.  Our focus today will be on the latter two, diversification and time, although having a disciplined financial plan and supporting it may be the most important of the three.  What do we see?

 

The following tables present intra-portfolio correlations for portfolios equally weighted between 1) countries, 2) industrial sectors, and 3) major asset classes, for time periods of from 3 months to ten years (in the case of Sector Diversification).  The intra-portfolio correlation can range from -1 to 1, with -1 representing the greatest amount of diversification and 1 representing the least diversification.  Another way to consider the intra-portfolio correlation is to subtract the intra-portfolio correlation from 1 and divide the result by 2 to provide the percentage of diversifiable risk that is removed from the portfolio through diversification.

 

	Country Diversification (15 countries)		Sector Diversification (10 sectors)		Major Asset Classes Diversification (13 asset classes)
	Intra-Portfolio Correlation	Rate of Return	Intra-Portfolio Correlation	Rate of Return	Intra-Portfolio Correlation	Rate of Return
10 year	NA	NA	0.64	1.4%	NA	NA
5 year	NA	NA	0.74	-0.2%	NA	NA
2 year	0.80	-5.2%	0.78	-8.0%	0.4	-7.0%
1 year	0.76	18.7%	0.80	16.2%	0.4	16.9%
6 month	0.79	-22.6%	0.84	-18.0%	0.4	-10.7%
3 month	0.84	-48.1%	0.87	-44.6%	0.4	-31.8%
1 month	0.83	4.2%	0.84	-36.1%	0.3	3.7%

Source: http://www.assetcorrelation.com/

 

The points I want the reader to consider are the following:

·         For the time periods we can observe, we find that the intra-portfolio correlation is, by and large, less the longer the period of time for which we have observations.  This is true for all but the best diversification strategy, major asset classes.  This demonstrates the importance of time to one’s investing strategy, as it takes time to reap the benefits of investment strategies.

·         Diversification across asset classes is superior to either diversification across market sectors and across countries, as a way to remove diversifiable risk from our portfolio.  This implies that asset class diversification should always be a part of our investment management plan, while we remain mindful of both country and sector diversification.  The asset classes used are represented by exchange traded funds and include TIPS; Gold; US Bonds; Emerging Market Bonds; Oil; Commodities; US Real Estate; International Real Estate; Emerging Markets; Europe, Australasia, Far East; US Small Cap Stocks; US Mid Cap Stocks; and US Large Cap Stocks.

What causes these results?  First, we know that to reduce risk you need to combine assets that have a low positive correlation or, ideally, a negative correlation with other assets.  Drawing from the two-year results, the longest time period we have for every category, we find that the level of positive correlation between groups is much greater for both the sector and the country results.  In fact, there are no negative correlations in either, while some mild positive correlations (between 0 and .80) exist.  Mild positive correlations exist in 40% of the sector correlations and in 23.8% of the country correlations.  On the other hand, for major asset classes, negative correlations exist in 20.5% of the correlations and mild positive correlations in 52.6% of the correlations or, rather, over 73% of the correlations are mild positive or negative correlations.

 

So, should you buy BP?  For financial success, my answer is simple, “It depends on what you need to add to your portfolio to reduce your diversifiable risk.”  If BP helps you reach your goals and reduce your diversifiable risk, I won’t discourage you from buying BP.  Otherwise, consider your total level of diversification and, perhaps, rebalance your assets with an eye toward diversification.