With the price of oil trading above $140 U.S. dollars today, many Canadians are concerned that oil is becoming a scarce resource and will continue to trade higher due to increased global demand, meaning an increased cost of living going forward. Conversely there are those that believe oil prices are being driven up by speculators and will soon correct downwards to the $80 - $90 level. This would likely create a sharp downward correction to the value of the S&P/TSX Composite Index, which is heavily resource weighted, and have a negative impact on your investment portfolio’s value.  

Which theory is correct and what should you do to protect your portfolio? Unfortunately we will only know that answer after the fact.

 

Although I didn’t specifically cover oil prices in my most recent article for Ontario Dentist, I did cover the theory of information cascades. The theory states that you will never have perfect information about what is going on in the market. You will have access to information, some of it good, some of it bad, and both types will influence your decision making process. It’s quite likely that during speculative periods you may be overly influenced by bad information (think about your actions during the internet bubble or U.S. housing boom) and take action that you later regret when that information is proven to be false. When it comes to oil prices, we will only truly know if the price is being determined by supply and demand concerns or speculators when one side is conclusively proven to be correct. For this reason I’ll continue to preach the same boring portfolio strategy for the major portion of your wealth:

 

·        Make sure that your portfolio is truly globally diversified

·        Clearly identify the broad asset classes (stocks, bonds, cash, etc…) and sub asset classes (large-cap stocks, small cap stocks, commodities, etc…) that you are going to invest in, and your portfolio’s desired weighting in each. 

·        As time goes on, have the discipline to rebalance back to the weightings defined above. This means selling some of your winners and reinvesting the proceeds into your losers.

 

Following the above strategy means that you should always have some exposure to assets, like commodities, that are experiencing a boom. This allows you to capture the increased returns being posted in that sector. Should the boom turn into a bubble, this strategy would also ensure that you don’t lose a significant portion of your wealth.