Lessons from BP — Look to ETFs for Portfolio Diversification and Market Efficiency

Americans today have various visceral feelings about British Petroleum (BP). Mostly, it conjures up pictures of oil-soaked creatures, executives sweating during their public flogging, government intervention, and ruined beaches. Aside from the tragedy, it reinforces two fundamental tenants of MarketRiders.

First, stock prices can be random, and it’s best to protect yourself. Don’t learn this the hard way: owning a portfolio of individual stocks that you think you “understand” is dangerous. BP has almost perfectly tracked the S&P 500 for years. Since April 26th, it has lost 50% of its value ($100 billion) due to a unpredictable event. Those who became comfortable with their stalwart, conservative bank and financial stocks (AIG, General Electric) learned about random events in 2008. Diversification means owning thousands of stocks and bonds in six or more asset classes using indexes and ETFs, not 20 stocks that you “like.”

Second, markets are mostly efficient. That’s because the smartest minds in the world are haggling over what companies are worth by trading shares all day. Buy a stock and 99% of the time, you are paying what it is worth. You aren’t getting a bargain, and you’re not going to “beat” the market.

Picture a gigantic computer, programmed with the best logic and infinite processing capacity, recalculating the value of all public companies every second of the day. On April 26 when the spill became front page news, BP dropped from $60 to $50 within days. The computer was busy digesting all the new data as daily shares traded spiked from 5 million to 156 million. By early June, as the spill worsened, the computer dropped BP below $30. Value investors estimated the spill’s damage against BP’s assets, cash flow, and litigation costs and bought from sellers who predicted bankruptcy. By June 10th, the computer was working overtime – 222 million shares were traded and BP closed near $31. But the computer was right: when a $20 billion settlement fund was announced a week later, BP’s price hardly budged.

Over a 10 – 30 year time horizon, you’re no match for the computer and neither is your financial adviser. It’ll out-think you. It’ll never get exhausted. Remember BP next time you are tempted to buy that stock you “like,” and then take that extra cash and rebalance your ETF portfolio.