Blind leading the blind

Here's a simple question: oil company has excess cash that it needs to invest, or return to shareholders. It acquires an internet company, saying it was doing it to get the best returns for its shareholders. The question is, do you believe the company did the right thing.

Basic business know-how tells you that this is a preposterous situation for a company, and any shareholder who buys this crap deserves to get their money taken from them. Internet companies have volatile returns because of their inherent risk, which is the source of the high returns as well as high losses.

But apparently that is not the correct answer, according to the Monkey Tutor they have "teaching" finance at Rockett Girlfriend's university. Apparently the oil company did the right thing because "risk = return" and because it diversifies the oil company's earnings stream.

Firstly, only ignorants who don't understand how business and markets work think that "risk = return". There is no God-given right to high returns just because you took great risks. However you do earn the rights to great losses if you are inept enough to put oil managers in charge of an internet company. Risk does not equal return - otherwise, what's so risky about it? This is a subtly important but highly misunderstood concept, and the misconception is spread because tutors (often students themselves) everywhere are careless with their teaching, or worse, don't understand the concept themselves.

As for the point on diversification, another misunderstood concept. Any basic corporate finance textbook will tell you that diversification has limited benefits, and these benefits almost always occur at portfolio level (where a portfolio manager acquires diversified shares) rather than at corporate level (where one company may acquire a company unrelated to itself). The risk of loss is magnified when you have one management team (say, from an oil company) taking over or presiding over the management of the unrelated firm (say, an internet company). So not only do you have the inherent business risk, you have added management risk - clearly antithetical to the whole point of diversification!

Theory aside, I am appalled that this tutor saw fit to confuse his students by using incorrect justifications. If he was trying to play "devil's advocate", the responsible thing to do was to clarify this, state the correct answer, and the correct responses against his "devil's advocate" response. To leave it up in the air causes two things to happen: to confuse a weaker student, and to convince the stronger student (or her Rockett Fuel boyfriend) that the tutor is an idiot.