9
July
2010
From time to time, we are asked for an opinion about some investment "opportunity". A while ago we were being asked if "now" was a good time to buy Irish Bank stocks and more recently the conversation has turned towards the opportunity to invest in BP plc created by the Gulf oil spill.
Our answer to these questions is always the same and is extremely simple.
Investors are not compensated for taking risks that they can diversify away and should not be buying shares in single companies.
Simply put, this means that speculation about the prospects for an individual company add unnecessary risks for an investor. At the extreme, these additional risks can completely wipe out an investment (Northern Rock, Anglo Irish Bank, Enron etc) which for many investors is simply too much risk for them to bear.
By contrast, investors can obtain the market return simply from buying and holding the market. There is no need to add the additional uncertainty from attempting to pick winning stocks.
The efficient market hypothesis states that prices reflect all available information. Therefore the risks to BP posed by the Gulf oil spill are already reflected in the price today. Future prices will be affected by future news stories which will be random and unpredictable in nature. It is unlikely that any individual can consistently make better guesses about the prospects for a company than the prices are currently indicating.
If investors require a higher expected return than the "market" which on average has tended to be around 10%pa for the last 100 years. They can tilt their portfolio towards smaller companies or value companies which on average are more risky than the market
For investors looking for less risk than the market, they simply need to decide how much of their capital to allocate to safer fixed interest Bond investments.
For a more detailed analysis on the history of BP's share price since 1988, please click on the image below
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Source: Bloomberg
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