Portfolio Diversification - The Free Lunch of Investing

“There’s no such thing as a free lunch.” We’ve all been warned about this many times, in many different situations, and for good reason. Whatever is being offered “for free” almost always involves a hidden cost or fee or imposes a future obligation, monetary or otherwise. We don’t expect to get something for nothing and should maintain a healthy suspicion about anyone who tries to convince us otherwise.

But when it comes to investing, you really can get something for free. It is available to everyone, not just the super-rich or super-sophisticated. It is absolutely real and entirely legal (and not fattening). What is it?

Diversification.

What Is Diversification?

Okay, that doesn’t sound very exciting. But diversifying your investment portfolio — in other words, spreading your money across different investments — is truly valuable and can be done by all investors, with no additional costs. Here’s an example of how diversification gives an investor something valuable for free:

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Example #1

Imagine you have an opportunity to buy a security whose price will either go up 6% or down 4% over the next 12 months. There is an equal chance of it going up or down. We’ll call this “Asset A.”

In statistical terms, Asset A has an “expected” return of 1%. (A 50% chance of going up 6% and a 50% chance of going down 4% works out to an expected return of 1%.) However, in any given 12-month period it won’t actually earn that “expected” 1% — it will either gain 6% or lose 4%.

You inquire about Asset A’s past performance and learn that there has been no predictable pattern to its ups and downs. Maybe it went up 6% three years in a row, then down 4% for two years, then up four years and back down for three. The pattern of “up” versus “down” has been entirely random.

You would probably consider Asset A to be a rather risky investment. I would. Even though it may feel like it should have a positive outcome in the long run, many “down” years could happen before an “up” year. It should feel risky. The chance of winning 6% isn’t big enough to entice me to risk the chance of losing 4%, especially if I can lose 4% many years in a row.

Example #2

Now imagine another investment, Asset B. It also goes up 6% or down 4% per year. But here’s the interesting thing: Whenever A has an “up” year, B has a “down” year, and vice versa. If A goes up by 6%, B goes down by 4%. And if A goes down by 4%, B goes up by 6%. Here comes the free lunch.

If you invest equal amounts of money in A and B — in other words, if you diversify your risk between these two investments with ups and downs that are perfectly offsetting — you will definitely earn 1%. For sure. With no risk.

Let’s say you invest $100 each in A and B, and this year, A goes up 6%, so B goes down 4%. You end up with $106 from A and $96 from B, a total of $202. If things had gone the other way and A had declined 4%, which would mean that B had increased 6%, you would still have $202. No matter what happens, you end up with $202. Since you started with $200 and now have $202, that’s a 1% return.

The fact that B moves exactly opposite to the way A moves allows us to eliminate all of the uncertainty, also known as risk, of buying just A or just B, simply by buying both A and B. And remember, it doesn’t cost us anything extra to do this. By dividing our money between these offsetting investments we eliminate the risk associated with holding just one or the other. Yup, something for nothing. Free lunch.

Now the Bad News

You knew there had to be some bad news. This example is greatly exaggerated. In the real world, we cannot find investment opportunities that perfectly offset each other like this, 100% of the time. But we can lower our risk without sacrificing return, simply by allocating our money across a sufficiently diverse array of investments.

Most exchange traded funds (ETFs) and mutual funds hold a fairly large number of different stocks or bonds. So they are inherently well diversified. Exceptions would be funds that invest in only one industry (e.g., only home builders or only solar energy firms) or in only an “emerging market” country whose economy depends largely on commodity prices or whose stocks are highly concentrated in one or two industries.

If you prefer to buy individual stocks rather than ETFs or mutual funds, you should invest in at least 20 different companies in different industries. There is math that shows why this works, but the main idea is that different investments don’t all move in the same direction at the same time. Even if one of your 20 stocks does poorly, chances are the others will do okay and some may do quite well, unless the entire market falls. Being diversified across asset types — meaning not just stocks but also bonds and a small amount of cash — reduces overall “market” risk.

Here’s Your Free Lunch

In other words, “Don’t put all of your eggs in one basket” — another wise piece of advice you’ve heard many times. When deciding where to invest your money, make sure to diversify. That’s all you need to do to get yourself some of that free lunch.