Free Lunch

In the post entitled risky business, we discussed the concept of “Beta.”

This term defines the risk, or volatility of the market Itself.

And with any individual investment, it’s generally true that there is no such thing as a free lunch. Put another way “No risk: no reward.”

An equally important, and less obvious point is that risk itself, decreases the efficiency of an investment. So two investments with identical average returns, but differing degrees of volatility (or risk) will favor the less risky asset in terms of the growth of a dollar invested over time (or annualized return.)

But it turns out that when it comes to investment portfolio construction, there is a free lunch: Diversification.

Diversification

The common conception of diversification is something along the lines of the old saying, “Don’t put all of your eggs in one basket.”

And this is right.

The classic example of the risk of an undiversified investment strategy is that of the Enron employee who has millions of Retirement dollars invested in Enron stock.

When Enron goes belly up, he loses everything.

Had he invested in the entire stock market, he would have lost very little value with the demise of one company. (To add insult to injury, this is also a great example of uncompensated risk…..Investing in one company adds significant risk without adding expected return…..nothing for something?)

But there’s another more interesting benefit to diversification. And this is where the free lunch comes in.

To borrow an example from William Bernstein’s “The intelligent asset allocator”, Imagine a coin which if it comes up tails loses $10 but if it comes up heads wins $20. This is analogous to a stock with both risk, and a risk premium. There is the risk of loss, but there is the probability of gain over time.

So if we flip the coin once, there’s a 50-50 chance that we win money or lose money. Our average return will be five dollars.

But what if we add another coin of half value (heads wins 10$ and tails loses 5$) and flip the two coins at the same time?

Now there is a 25% chance we will win $20 (heads/heads), There’s a 25% chance will lose $10 (tail/tails),
And there’s a 50% chance that will win $5 (heads/tales, tales/heads)

So now There’s a 75% chance of winning money, Each time we play.

Our chance of winning is tripled, And our chance of losing is halved. And although our average result remains unchanged at positive five dollars, The standard deviation, or risk is significantly lessened. This means that over time, our annualized return will be greater in the second scenario. (This represents the money that you actually get to keep…. which is kind of the point of investing.)

The reason why this works, is that the coins are completely uncorrelated… The result of one coin flip has absolutely no effect on the results of the other. This smooths out the jagged edges of volatility in the results curve of the coin flips.

And notice that the fundamental characteristics of risk and return in the individual investments (coins) have remained unchanged.

This is where the free lunch comes in: Diversification increases actual returns, without increasing risk (in fact it decreases risk.)

So the take-home message is this: When we build an investment portfolio we will look for multiple (low cost) asset classes that have low correlation with each other in order to improve the overall performance of our portfolio.

But don’t take my word for it, read some books!

After all, I’m only a doctor.