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Free Lunches in Investing

“There’s no such thing as a free lunch.”

It’s a basic economic principle. But from the perspective of an individual investor, it isn’t true.

Diversification is a Free Lunch

Imagine that your portfolio consists of 10 randomly selected stocks. If, instead, you held 20 randomly selected stocks, the expected return of your portfolio would be the same, but you would be exposed to less risk. And if you held hundreds or thousands of randomly selected stocks, the expected return would still be the same, but you would be exposed to even less risk.

Point being: as long as there is no (or minimal) cost to actually achieve the diversification, you get a free lunch — risk reduction with no downside.

A counterpoint is that if you own just 10 stocks, they probably aren’t randomly selected. You probably picked them because you have reason to think they’ll earn above-average returns, and therefore if you switch to a more diversified portfolio, yes, your risk will go down, but your expected return will decrease as well.

That’s true of course — if you are one of the few people who can successfully pick winning stocks. Most investors, myself included, have no reason to think that we are smarter than the collective wisdom of the market. For most of us, even if we think we’ve selected 10 great stocks, our results are not likely to be any better than random selection. (And we might as well just diversify instead, in order to get the risk reduction.)

Reducing Costs is a Free Lunch

When it comes to mutual funds, a reliable phenomenon is that funds with lower expense ratios tend to outperform funds with higher expense ratios. Even if you’re dead-set on trying to outperform the market via actively managed mutual funds, you dramatically improve your chances by using funds with low costs.

By using funds with lower expense ratios, you increase the expected return of your portfolio, without any downside. (That is, you get a free lunch in that you’re no longer paying for somebody else’s lunch.)

That said, it’s important to keep costs in perspective. The savings from reducing the costs of your portfolio from, say, 1% per year to 0.2% per year are dramatic when compounded over a few decades. In contrast, the savings from trying to pick the very least expensive index funds or ETFs (e.g., worrying about the difference between a 0.05% and 0.06% expense ratio), are slim to nonexistent.

CDs Are a Free Lunch (Sort of)

As author/advisor Allan Roth has pointed out repeatedly over the last several years, CDs are often a free lunch relative to bond funds.

By shopping around for yields, you can find a meaningfully higher yield than you’d get from Treasury bonds, despite having no additional risk of default (as long as you stay within FDIC insurance limits). And in some cases you can even have less interest rate risk too, if you find CDs that allow for early redemption with only a small penalty.

This extra yield persists because the FDIC limit keeps large institutional investors from scooping CDs up in huge amounts and driving yields back down to match Treasury yields.

Point being: if you’re going to try to actively manage your portfolio, you’re more likely to find a free lunch by imitating your grandparents — shopping around for CD rates — rather than trying to imitate Warren Buffett.

That said, there is a time cost involved, so it’s not truly a free lunch. But for anybody with significant fixed-income savings, the payoff relative to time spent can be super high.

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