Proving the familiar saying untrue; I’ll show you how to increase your investment returns without increasing risk.
Many phrases and idioms in the english language are passed down from parent to child. They might be shouted in despair, or whispered in consolation. These phrases become an inherited wisdom for the next generation.
One such lesson is ‘There’s no such thing as a free lunch.’
Apparently this adage was originally used to warn against ‘free lunch’ offers that bars would use to entice drinking customers. While the food would be a steal, their drinks would be priced at a high margin, therefore the bar would generate a healthy profit nethertheless.
The Free Lunches with a Hidden Cost
It’s a very sensible piece of general advice and is often quoted in the best investing books. I can think of several examples where it applies to investing:
- A financial services firm has no incentive to offer you a free/discounted service unless they’re planning on charging you fees some other way.
Example: Low trading fees but high periodic account charges or ‘platform charges’.
- A financial advisor offering ‘free’ advice is probably work for commission and could be tied to a particular product or investment. Therefore, while their services might appear to be free, their advice may not be unbiased, and their fees will be hidden within the management charge of your investment.
Example: An advisor based at a bank, who directs you towards expensive mutual funds.
- An investment offering a higher return is very likely to contain higher risk, whether you can perceive them or not.
Example: Peer to peer lending platforms often feature loans which offer a 10%+ interest rate. For an investor seeking an 8% return, this can be appealing. However, after factoring in bad debts and volatility, this investment may not help them achieve their objectives.
- An opportunity which appears to offer superior returns or unusually low risk could be a trap. Investment fraudsters will often make their investments look very attractive to encourage enquiries. (See also: ‘If something looks too good to be true, it probably is.’)
Example: “Guaranteed 70% returns each year, projected returns of 300% over 5 years!!!”
However, there is a single case that breaks the rule entirely. There is something you can do as an investor which will provide a benefit with no downside.
The Truly Free Lunch: Diversification
To understand why diversification is a free lunch, I need to quickly explain some stock pricing and risk theory.
The risk of a stock can be measured by how volatile the stock price is. A stock which doubles in value one year, then falls by 80% the next would be considered high risk on this basis.
You can split the cause of these price movements into two types of news:
- News which relates to this individual company, and therefore only impacts the individual stock price.
Example: Company X releases new product to critical acclaim!
- News relating to the wider economy or political environment which impacts entire industries and therefore stock prices across the board.
Example: Bank of England increases interest rates in an attempt to curb inflation.
These risks stack on top of one another. A business could announce it has been the victim of fraud (Risk A), on the same day that the economy enters a recession (Risk B), triggering a double blow to their stock price.
So investors need to worry about both…right? They need to factor both risks in when assessing an investment?
Well, the truth may surprise you. Thanks to the first truly free lunch, you don’t actually need to worry about Risk A. That free lunch is diversification.
How Diversification Actually Works
Diversification works because specific news is effectively random. It’s unpredictable. Rather than this being a problem, it’s actually a very useful characteristic.
How can I be sure that it is random? Well, if the market is realistic about a company’s prospects, then by definition, any future news is equally likely to be positive or negative.
To think of it another way, if one type of news was more likely than the other, then we would conclude that the current market outlook is either too pessimistic or optimistic.
The pricing of markets, in theory, will constantly adjust the price of a stock to incorporate all known information to produce a neutral outlook. This happens because traders can buy or sell stocks with blatantly optimistic or pessimistic prices and profit from these pricing anomalies. This activity nudges the prices of the stocks back to neutral territory.
So how does this link back to diversification? Well, because these ups and downs are random, you can eliminate the risk by holding many different stocks.
On any given day, some of your stocks will have enjoyed positive news, and some negative news. These will partially or completely offset each other.
The larger your basket of stocks, the more consistently this will occur and the more neatly this risk will eliminate.
Let’s show this actually happening by using a coin to represent a stock. A flip of this coin represents the effect of specific daily news on the stock price. Heads represents good news and gives you +1 point, and tails represents negative news and gives you -1 point.
Your running score after a week (7 flips) would show the cumulative impact that specific news has had on your investment portfolio over that period.
Playing with only a single coin you could find yourself on an unlucky streak of bad news three days in a row. This would give you a score of -3 and there’s a ⅛ chance of this happening. This represents the exposure you have to Risk A when holding only one stock.
When I ran this experiment for 7 ‘days’ (flips), I ended with a running score of 2. Let’s divide this by the number of coins to give an impact per coin of 2/1 = 2.
If you diversify by now using five coins, you’ll immediately see more mixed results each flip. A three day loss streak is now virtually impossible; as this would require all five coins to land tails for three flips in a row. This has only a 1 in 32,000 chance.
Over 7 flips, I scored -3 using 5 coins. This gave an impact per coin of -3/5 = -0.6
Now imagine that you flip 100 coins per day. With such a large number of coins, it’s quite likely that the balance between heads and tails will be close to 50% every day. I used a coin flip simulator online to run this experiment, and found that even after 30 flips, the most extreme imbalance was 43 heads v 57 tails.
Over a simulated week, I scored +36 on 100 coins, giving an impact per coin of just 0.36
As you can see, even over very short periods the impact of truly random positive or negative events begins to approach zero as you increase the number of investments. As any wealth calculator will show you, the less extreme these positive and negative days are, the smoother the ride you’ll experience in your total portfolio value over time.
This is why diversification is a free lunch. By dividing up your money over many investments, you can almost eliminate an entire category of risk entirely.
Keeping it Free: How to be cost effective
Yet diversification is only a free lunch if you can diversify at an insignificant cost. This is easier said than done.
If you manage a basket of stocks using a stockbroker account, you are probably turning blue at the thought of paying your stockbroker for 100 different trades to build your portfolio.
So here are some tips for achieving the benefits of diversification, without funding your stockbrokers next bonus check:
- Be practical. The effect of diversification has diminishing returns. This means that past 20+ investments, each additional investment adds very little impact. This is why many investors aim for a basket of this size when trading individual stocks. It’s a natural balancing point between risk protection and expense.
- Leverage the scale of pooled investments. Mutual funds and Exchange Traded Funds (ETFs) can manage portfolios of over 100 investments at very low cost because they can make fewer, larger trades.
The number of trades that a fund needs to execute to maintain an investment strategy does not increase in proportion to the size of the fund, meaning that large funds can spread their trading costs across so much capital that these costs become vanishingly small, e.g. < 0.2%.
Better still, these funds can often be bought for zero fees upfront if you choose the right stockbroker. Meaning you could get access to instant diversification for a fraction of a % annually.