Golden opportunity or total deception?
March 16, 2015
High returns and low risks seem like an attractive combination, but are they are a golden opportunity for total deception, wonders Arco van de Ven in this column.
Image: © Nationale Beeldbank
Do you sometimes watch Business Class, a Dutch TV program by Harry Mens, on Sunday morning? It’s a compelling show. What strikes me are the various consultants who come along and how they dispense advice with such certainty. They often outline investment opportunities where high returns appear to be associated with low risks.
Burton Malkiel, in his book A Random Walk Down Wall Street, convincingly shows that a perfect strategy that given time seems to perform better than the market, is an illusion. He provides a good example: an experiment that creates a price movement graph by flipping a coin. Students had to flip a coin and when heads came face-up they had to record half a point up, and when tails came face-up half a point down. When showing this chart to a technical analyst, he said: “What is this company? We’ve got to buy this immediately. This pattern is a classic. There’s no question this stock will be up 15 points next week.” A fake fund that moves totally randomly, thus suddenly becomes a golden opportunity. How crazy can it get?
That is also the feeling I get with a lot of investment advice.
High returns and low risk seem like an attractive combination, but the propositions are unfortunately usually based on an incorrect estimate of the returns, risks, or of both risk and return.
Let me give you an example. The other day I heard the following investment advice that I would like to share with you. If you had invested in Dow Jones in recent weeks, you would have made a 10% return. Unfortunately for you, the dollar decreased by 10% in the same period, so, on balance, this investment did not give any return.
However, if you had hedged the currency risk with a financial instrument, you would have made a 10% return. A truth you cannot argue against. Except, of course, that the cost of the financial instrument should also be included. But is the “invest in the Dow Jones index and hedge currency risks” advice any good?
The weak point of the story is, of course, that determining what investment advice would have been successful, given the knowledge of currency movements, is very simple in hindsight. But the advice would have played out much worse if Dow Jones had decreased by 10% and the dollar had increased by 10%. And after the crisis we know as never before that predicting stock market and currency movements is akin to fortune-telling and that there is no return without risk.
Therefore, I proffer the following free advice. If it seems too good to be true, it probably is. Employ some professional skepticism, or in plain English: common sense is the most important adviser when it comes to distinguishing between opportunities and deception.
Prof. Dr. Arco van de Ven, CPA, Professor of Accounting Information Systems at TIAS School for Business and Society of the University of Tilburg. This column originally appeared in Dutch-language ControllersMagazine.