Question

1. Suppose Emma holds a well-diversified stock portfolio. Her son, Andrew, who is a portfolio manager, has just advised her not to invest in stocks of oil refining industry because their prices tend to have much higher volatility relative to other stocks. Is Andrew’s advice sound? Explain.

Answer 1

The prices of oil has recently gone into a negative zone and it was completely unexpected because it has never happened before in the history of commodity markets. It is having higher volatility and higher uncertainty which is leading to wild movements leading to sharp rise in volatility.

In this case, Emma already holds well diversified portfolio and she wants to take exposure in oil, I will recommend her to allocate very little amount of her portfolio into this commodity, because this commodity is highly dependent upon the pricing fixation of various member nations of OPEC and it is highly fluctuating in nature so it could be more volatile than stock at times as there is high level of uncertainty attached to it due to uncertainty in fixation of a price amid environment of Weak Global demand.

since her portfolio is well diversified, she should not invest more into the commodities space, she should always be looking for investing a very little in order to gain from higher volatility and should be still hedged as her portfolio is well diversified and well allocated into various classes so that a little exposure will not expose to high risk.

I would slightly differ with her son who is advocating against investment into oil, by reasoning that Oil has corrected sharply and it can show sharp recovery on the way upside, so it can even lead to gains in the long-term, so I'd be advocating for allocating a smaller proportion of her overall portfolio to oil.