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The oil spill in the Gulf of Mexico is tragic on a number of levels, most important being the loss of eleven lives, workers on the BP oil rig. We can add to that the potential life changing disruption for the people living along the Gulf Coast, the environment, the economy and the loss of animal life. Furthermore, the potential for the spilt oil to eventually travel around Florida and up the Atlantic Coast is nearly unimaginable. That said, investors can also glean several valuable lessons from this event.
Probably the most important lesson that investors can learn from this tragedy is that diversification is of utmost importance when it comes to investing in individual securities. Let’s assume that your portfolio totaled approximately $100,000 and that at the time of the spill you owned 100 shares of BP which was then trading at around $59.50 per share for a value of $5,950. BP therefore represented 5.95% of your portfolio. Today, BP trades at or around $34.50 per share and has acted as a 2.50% drag on your portfolio relative to the stock market. That’s not great, but it will not destroy your portfolio. You will live to fight another day.
Investors should also diversify across sectors of the economy. Since the oil spill, not only has the stock price of BP been pummeled, but so has those of deep-water drillers as well as oil service companies. It is appropriate to slightly overweight an industry. However, to grossly overweight an industry is like playing with fire. You can get burnt. Lesson number one. Diversify among companies (at least twelve to fifteen) and across industries.
Don’t chase companies solely for the dividend. The landscape is strewn with companies that used to pay high dividends only to then have to cut that dividend as a result of poor market conditions, changes in government legislation or poor company performance. Some of the “widow and orphan” stocks that investors relied on for income have severely cut their dividend over the past couple of years. Consider General Electric, Bank of America, KeyCorp and JP Morgan Chase, just to name a few. BP pays out $3.36 per year in the form of a dividend. At the time of the disaster that would have resulted in a dividend yield of 5.65%, attractive to many investors. Today, due to the decline in the share price that yield approaches 9.00%. However, don’t be surprised if BP either cuts, suspends or eliminates their dividend to conserve cash during this period of uncertainty for the company.
Finally, remember that nothing is for certain and to think you “know” what is going to transpire or you “know” that BP is a good buy at these levels is arrogant. Investing is like eating ice cream, everything in moderation.
THE BOTTOM LINE – Investors would be wise to diversify across companies, across industries not invest solely for dividend income. This should help preserve sudden portfolio drops due to changes in the outlook of a company or an industry.