The price of oil recently fell below $40 per barrel, attracting attention in the media, given that oil was trading over $100 per barrel last year. A falling oil price is generally bad for the stocks of energy producers. On the other hand, it can be positive for companies that use oil in their products and services from airlines to chemical companies, since their input costs will typically fall as a result of lower oil prices. This is one example of how a diversified portfolio can help manage risk. What hurts one sector of the economy, or stock market, can help another.
Also, remember that historical context can be useful. For example, in March 1999 the oil price fell to $10 a barrel and a cover article in the Economist, titled â€œDrowning in oilâ€ mentioned that the oil price could fall further to $5. In fact, over the following 12 months the price of oil tripled. We use this example not to forecast the oil price, but to illustrate just how challenging it can be to make short-term predictions.
What can be helpful in situations such as this is a concept known as value investing. This is not attempting to predict the future, but looking to add potentially less expensive stocks to your portfolio based on current metrics.
Looking at US stock performance data from July 1963 to December 1990, Fama and French found that holding less expensive stocks (as assessed on a price/book value basis) historically boosted returns by 0.42% per month or 5.1% a year, on average, relative to holding a portfolio of stocks that appeared to be at an average valuation using the same approach. Value investing is an approach we look to implement by holding value tilted ETFs in our stock allocation, as well as our automatic rebalancing process across asset classes.