BP Teaches Three Key Investment Lessons

Last Updated Jun 17, 2010 12:37 PM EDT

The British Petroleum Gulf disaster continues to drag on with no light at the end of the tunnel. The plunge of BP's stock price was predictive of the scope of the disaster as Obama has now obtained a commitment of $20 billion from BP, in addition to a dividend suspension. It's a tragic story, but also one that offers investors beneficial lessons on stocks when they have lost about half of their value. If you own a chunk of BP, be forewarned that this may be a painful read.

Diversification matters
Let me first state the obvious by saying that owning any one stock is far more risky than owning the stock market as a whole. BP started the year as one of the most valuable companies on the planet as measured by market capitalization. Yet it was only one company. Markets have stayed pretty flat so far this year, but a 50 percent decline in BP stock would equate to a 5 percent decline if your portfolio had ten stocks. Picking individual stocks increases risk without increasing expected return.

Dividends can lead to disaster
Only two years ago, investors learned the hard way that dividend investing can be hazardous to your wealth. In 2007, high dividend companies were heavily financially oriented and those were the stocks that got slammed the worst. As time passed, and memories faded, those lessons went wasted and investors returned to chasing dividends like a yellow lab after a Frisbee. Though BP paid a great dividend, and we all like income, it's the total return that matters.

The unlikely always happens

Don't confuse the unlikely with the impossible. The collapse of such titans as Enron, Lehman Brothers, and General Motors, could never happen to BP, right? BP, after all, has billions of barrels of proven oil reserves which is money in the bank. Well, even if you believe BP's claim that multiple fail safe systems on the rig failing at the same time was a once in a millennium event, keep in mind that there are hundreds of rigs in our oceans. This fact alone increases the likelihood of at least one failure.

Unlikely events are very likely to continue to happen every day. It's one of the few things that I can actually guarantee.

My advice
You need thousands of stocks to build a diversified portfolio and broad index funds will minimize the risk of an unlucky pick. I cash every dividend check I get, but buying mostly high dividend stocks or high yield bonds is a recipe for failure. Finally, build your portfolio knowing that the unlikely will happen. Make sure part of your portfolio has bonds backed by the U.S. Government that can act as a shock absorber every time the unlikely happens.

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    Allan S. Roth is the founder of Wealth Logic, an hourly based financial planning and investment advisory firm that advises clients with portfolios ranging from $10,000 to over $50 million. The author of How a Second Grader Beats Wall Street, Roth teaches investments and behavioral finance at the University of Denver and is a frequent speaker. He is required by law to note that his columns are not meant as specific investment advice, since any advice of that sort would need to take into account such things as each reader's willingness and need to take risk. His columns will specifically avoid the foolishness of predicting the next hot stock or what the stock market will do next month.