The recent attempt by Chevron (CVX) to purchase Anadarko (APC) provides investors with a strong reminder of the power of diversification. The fact that Occidental (OXY) recently stepped in with a sweeter offer only reinforces this lesson.
No matter which company ultimately lands Anadarko, the narrative of the deal can basically be summed up as a "big oil" buying into "shale oil.” Shale companies emerged in the 21st century due to their embrace of new technologies such as hydraulic fracking and horizontal drilling - both of which has allowed them access to oil and gas reserves in the United States that were previously viewed as too expensive to reach.
The emergence of the shale industry is no small thing, as has launched the United States back into the top three countries worldwide in terms of daily crude production. The value of Anadarko to Chevron/Occidental appears to have hinged on the fact that Anadarko is the second-biggest producer in the Permian Basin (which is the most productive shale oil field in the United States and located in Texas).
Circling back to the topic of diversification, energy investors holding a broader portfolio of companies probably benefited more from this recent acquisition than those holding only one or two companies - especially if that one or two did not include APC.
Besides the 33% jump in Anadarko's stock price, the entire shale subsector rallied extensively in the wake of the takeout news - further boosting the holdings of well-diversified energy investors. Traders looking to learn more about diversification would be well-advised to review a new episode of Options Jive.
Entitled "Demonstrating Diversification," the show highlights a new study by tastytrade that backtests the historical performance of a range of portfolios. The purpose of this exercise is to compare the returns of a portfolio exposed to one single stock versus a portfolio that invests evenly in a diversified group of stocks.
While the full parameters of the study are outlined on the show, the basic premise was to invest $1,000,000 starting back in 2005, and then backtest the performance of each "portfolio." As you can see below, there was a wide range in terms of performance - from laggards to stars - which means trying to pick the best performer of the group nearly 15 years ago was probably akin to a coin flip.
The second slide illustrates the performance of the diversified portfolio (the red line labeled "port") as compared to performance of each single stock:
As you can see in the second slide above, the portfolio that evenly invested in each of the seven stocks produced an attractive return - and didn't require the investor to choose correctly at the outset.
More importantly, the Options Jive team also analyzed this approach from the perspective of risk, and discovered the annualized volatility in the diversified portfolio was also at the lower end of the range when compared to any of the single-stock portfolios. More details on the complete risk analysis are included in the complete episode.
In sum, the study helped demonstrate how spreading risk across a basket of stocks not only helped reduce the overall volatility of the portfolio, but also helped balance risk versus return. This serves a good reminder that adding other asset classes (such as options and futures) can further diversify a given portfolio.
Along those same lines, Chevron and Occidental have made their own resounding statements on the value of diversification - they are both trying to add a large shale holding to their portfolios in order to diversify their energy investments.
We hope you'll take the time to review the complete episode of Options Jive focusing on diversification when your schedule allows. For more information on diversifying by strategy, instead of merely product, we also recommend this previous installment of Market Measures.
If you have any questions about this topic, or any other trading-related query, don’t hesitate to reach out on Twitter (@tastytrade) or email (email@example.com), or leave a message in the space below.
Thanks for reading!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.