Free Lunch

The common phrase “there's no such thing as a free lunch” was made famous by the Nobel-Prize winning economist Dr. Milton Friedman. In economic terms, it means that everything must be paid for by someone in some way.

Have you ever been invited to a lunch or dinner at a nice restaurant by a local investment advisor? If you think the meal is really free, think again. There will be a cost, which could range anywhere from relatively small to extremely expensive.

First, there would be an expense for gasoline to drive to the event. This alone would be a small price to pay for a nice meal - but there is also a hidden “opportunity cost” - because your time is worth something, isn’t it? After all, you could have done something else with your time. You might have engaged in an activity to earn additional income or used the time to fix something around the house, rather than hiring a repairman. At the very least, you could have done something more fun or pursued a legitimate educational opportunity.

Sometimes, I think people who attend such events are hungry for information. If the information presented is not truly valuable, though, you could be worse off despite the complementary meal. Taking it a step further, there is a good chance that you would receive very bad information. These folks offer such a lavish spread for a reason. If you succumb to the inevitable sales pitch for an inappropriate product or service, you could end up paying a heavy price. The unfortunate few who fall victim to these tactics essentially pay the bill for all of the attendees.

Even so, it occurs to me that there actually might be a way to get an economic free lunch. The concept of diversification provides great benefits with very little, if any, cost. Diversification means dividing your investments into different categories called asset classes, such as stocks, bonds, cash, and real estate. By doing this, you can potentially increase your investment return, reduce your risk, or even a combination of the two.

Larry Swedroe illustrates this concept in his blog entitled How to Build a Diversified Portfolio. He starts with a basic two asset portfolio and uses an index fund’s performance over a 35-year period. He goes through a step-by-step process of adding new asset classes to show the affect of diversification. In each step, the portfolio becomes more efficient.

By adding international stocks, the return increases while the volatility remains the same. This highlights the reason that I include international stock exposure in almost every portfolio that I design for clients. If you can enhance your investment return without incurring additional risk, why not diversify into international stocks?

You can see that when he adds small company stocks to the portfolio, both the risk and the return increase. However, the return increases so dramatically that diversifying with small cap stocks provides a favorable trade-off for someone who doesn’t mind the extra volatility.

Throughout this blog, Swedroe goes on to add value stocks and commodities to the mix. The ending portfolio has an annual return that is 1.1% higher than the beginning portfolio with the same level of risk. As attractive as this seems, I think this example understates the benefits of diversification. Real estate was not included in this study and the data presented was only since 1975. I believe that more years of data would paint an even more favorable picture of diversification.

The presentation clearly shows that the simple act of diversifying a portfolio can have one of the following results:

1. Generate a higher return with the same or lower risk;
2. Achieve an equal return, but with lower risk; or
3. Increase your return, while at the same time decreasing your risk.

Any of these results would be a vast improvement. In real life, though, it might not be totally free because certain funds can cost more than others. For instance, small company funds have traditionally sported higher expense ratios than the typical large cap domestic stock fund. Fortunately, this disparity has been largely eliminated in recent years as index funds and ETFs have allowed investors to participate in other markets with little if any additional cost.

Although I continue to subscribe to the theory that there is no “free lunch,” because this premise holds up well in so many areas of economic life. Even so, I can’t help but think that diversification might be a possible exception to that rule. Although diversification may not be “free,” it certainly offers you a great bargain all by itself (without the need for any coupons, sales pitches, or gimmicks).