Diversification: The Only Free Lunch

One of the most basic principles of economics is the idea that “there’s no such thing as a free lunch.” In other words, every good/service has a cost to somebody somewhere, regardless of whether or not the person consuming the service is the person paying. (Example: Google is free to users, because it’s paid for by a massive network of advertisers.)

That’s why I was fascinated to read (in Peter Bernstein’s Against the Gods) that in 1952, a gentleman by the name of Harry Markowitz proposed the idea that diversification is in fact a “free lunch.” That is, it offers benefits without any cost.

The more I think about it, the more I’m convinced that he was right. If you compare the likely returns between:

• a group of 5 stocks, or
• a group of several thousand stocks

…the “expected return” for either group of stocks should be the same. That is, there’s little reason to expect that either group will outperform the other.

What is different between the two groups, however, is the predictability of long-term returns. With a group of just 5 stocks, returns are extremely unpredictable. In contrast, we can at least make some sort of ballpark-estimate of the long-term returns of a group of several thousand stocks.

And you know what? Predictability of returns is kind of nice. 🙂

So what makes this “lunch” free?

I think we can all agree that this predictability offered by diversification is a beneficial thing. But what makes it unique is that it literally has no cost.

Sure, there’s a reduced chance of earning spectacularly high returns with a thousand-stock portfolio. But at the same time, there’s a reduced chance of earning spectacularly low returns. The two should precisely offset each other.

What about the actual costs involved with acquiring (and owning) a diversified portfolio? With low-cost index funds, or ETFs purchased via discount brokerage firms, they’re pretty close to zero as well. Or more to the point, they’re no greater than the costs involved in acquiring and owning a undiversified portfolio.

It’s always been obvious that diversification is a good thing, but I’d certainly never thought about it in these terms. Something beneficial that costs you literally nothing. Might as well take advantage, right? 🙂