The Rush to Buy This Oil ETF Shows 4 Common Mistakes that a Retail Investor Usually Makes
By: Jo. Young
Tags: Money, Economics, Finance, Investing, Stock Market

If you are someone who follows the financial market news recently, you probably heard about the collapse of crude oil prices earlier this week. On 20th April 2020, the price of a barrel of oil plunged below zero dollars for the first time in history. The reasons are simple — an oversupply and a complete lack of demand for oil plus a lack of storage to store the extra barrels of oil imply that oil is effectively worthless now.

As oil prices are dirt cheap right now, it seems like this is an excellent opportunity to invest in oil. An easy way is to look for a popular oil ETF and pour your cash into it. However, if only investing is so easy, everyone would have been rich.

What happened last week has shown us four common mistakes that a retail investor usually makes when it comes to investing.

Ok, so what happened?

The rush to buy United States Oil ETF (USO)

The United States Oil ETF (USO) was meant to track the price of West Texas Intermediate (WTI) oil. Specifically, it follows the front-month oil futures contract, not the spot price of oil. As the price of USO plummeted below $3 earlier this week, roughly down 45% this month, many young retail investors flocked to buy this ETF, erroneously thinking that it is one of the greatest buys of the time.

So what’s wrong

Commodity ETFs do not necessarily reflect the changes in the underlying price of a commodity. They follow the price of the shortest-dated futures contract in that commodity available at a given time. These funds buy short-dated futures.

In the case of oil, because the demand for oil is not going to increase very much soon, those who bought up the short-dated futures contracts will sell the contracts once they expired. They will then replace them with longer-dated ones, which are more expensive — storage for oil becomes increasingly difficult and, thus, expensive.

Long story short, investors who have invested in USO are in for a significant loss.

What are the 4 common investment mistakes made?

I am not going to continue to elaborate on the specifics as I will leave that for the real experts in this field. More importantly, I want to use this example to highlight that as retail investors; there are mistakes commonly made BUT can be prevented without much effort.

#1. Invest in something you don’t completely understand

In this case, some retail investors have mistaken USO as an indicator of oil spot prices and thought that they should cash in this opportunity. You might think that as long as it’s for the long term, things don’t really matter. However, in this case, this ETF is also not designed for long-term holding. Not all investible assets are designed for long-term holding.

Even if this ETF proves to be a substantial potential investment, one should never invest in something they don’t understand. You rather profit less investing in something you comprehend than risk losing in something you don’t.

#2 Cheap doesn’t mean it’s a good buy

Assuming you know what this ETF is all about and it is really dirt cheap right now. Don’t buy the dip for the sake of doing it. Not all companies or stocks that are doing badly now will rebound to the same, if not higher, levels as they were before. Some just continue to spiral downwards and becomes a gone case sooner than you think.

While the demand for oil will rebound one day, this ETF does not track the spot price for oil. Since Wednesday, oil has rebounded considerably, but USO has barely shifted away from its lows.

This links back to my first point — don’t invest in something you are unsure of.

#3 An investment that has done well in the past does not mean it will do well forever

While USO’s price chart has been ‘rather stable’ for the past few years, experienced investors have shown us that the USO hasn’t actually tracked the price of WTI oil for the past few months. It turns out that USO’s investment managers have changed their direction recently.

This implies that even if you are investing in one of the safest assets in the world, it does not hurt to keep yourself updated on the performance of the asset from time to time. Do that when you review and readjust your portfolio.

#4 Don’t forecast for the sake of forecasting

In other words, don’t speculate if you are not as informed or you are not a big risk-taker. While demand for oil will recover once the global economy starts ramping up, we don’t know when exactly that will take place. Some say coronavirus will take at least another year to ‘disappear,’ some say it might end up as a more lethal seasonal flu. While some countries are opening up their economies, everyone is still cautious.

Besides, the oil that is unused now is in so much excess that it will take months for the economy to burn off. The oil market could remain oversupplied for the remaining months of 2020, thus suppressing oil prices. Some oil companies may go bankrupt as a result. I really don’t know.

Thus, in times like this, don’t invest just because you ‘think’ things will get better. Yes, it will get better, but before it gets better, no one knows how much worse it will get first — can you take the risk?

Conclusion

Nevertheless, don’t fret. This does not mean that we don’t invest at all since all investments carry a certain risk. This just means that you shouldn’t join the herd and try to forecast things. The greatest investors of today, like Warren Buffett, Charlie Munger, Howard Marks, and Ray Dalio, have repeatedly warned us against doing these things. You may ‘buy the dip’ if and only if there is a sufficient basis for believing that the price being paid is substantially lower than the value being delivered.

Meanwhile, stay safe and healthy!