The Only 'Free Lunch' in Finance

May. 19, 2020

As the infamous saying goes - in life there are no ‘free lunches’. What about in finance? Paolo Sodini, Professor at the Swedish House of Finance and a founder of the Centre for Economic Policy Research Network on Household Finance has spent the last two decades investigating this and other topics to help people fare better in their personal finances. Seated in his home study, he holds in a laugh and smiles instead as he reveals that there is, in fact, one: “The only ‘free lunch’ in finance is to diversify rather than to concentrate savings.”

What Is Diversification?

Diversification means combining a portfolio of financial assets together instead of concentrating the wealth of your savings in few or even one asset. Critics of diversification argue that it is complex, even expensive. Yet such facts virtually hold no water in the present day, since it is not only easy to diversify but also cheap. Today there are mutual funds - person A hands over money to a manager in charge of the fund, the manager decides how to invest and person A receives a fully diversified portfolio. Another good way to diversify are index funds - and they are economical too. In Europe, an average fund costs 2 percent in fees while the world index trades for as low as 0.1 percent in Sweden. At the end of the day the big decision, the Professor says, is not whether to diversify or not, but rather: “To diversify, pay little, and decide how much to save every month and so on."

 

Why Is Diversification a ‘Free Lunch’?

To understand why, the Professor says, one must first think about risk. Whenever a person invests in risky assets, there are different types of risk. Professionals, pension funds, wealth funds and so forth do diversify and subsequently only require compensation for the risk that is systemic. Diversification, therefore, aims to diversify away risk that is not systemic - idiosyncratic risk. That is, risk related to companies being exposed to specific shocks. Think about the analogy of two sectors: airline companies and oil companies in which returns may be similar. Person Y bets on airline companies and person Z invests in oil companies. If oil prices go up, oil companies gain and airline companies lose, and vice versa if oil prices drop. If person Y or Z buys the sectors separately, gains and losses are dependent on oil prices going up or down. If they, however, combine the two together, they eliminate the idiosyncratic risk but still earn the same return - a free lunch.

Better still, why limit yourself to two sectors? In wake of the widespread pandemic both oil companies and airline companies have dropped - a fairly unprecedented trend. In this case person Y and Z would have been far better off had they also bought a technology company, an online entertainment company and perhaps a pharmaceutical company ex ante. Shielding from idiosyncratic risk through diversification, the Professor admits, even extends to the celebrated teleconferencing sector: “Some of them turned out to be much less secure and had privacy issues that were not dealt with before the massive volume of traffic hit. The sector has exploded, but still some companies benefited more than others due to idiosyncratic reasons.” Principally, diversification adds counterweights to idiosyncratic risk, individual fortunes and misfortunes, but keeps returns at a steady level. In this sense, diversification is a ‘free lunch.’

 

If Diversification Is a ‘Free Lunch,’ How Come Not All People diversify?

A major fallacy of it, the Professor explains, is that people are drawn to and tend to trust the familiar. Home-bias becomes a driver and makes people choose stocks of their own country, or stocks that are familiar - for example a person with a Volvo decides to bet their money on Volvo stock, which some evidence suggests. Nevertheless, soley investing in stocks in the home-market comes with a devastating drawback. Concentrating savings, the Professor says, means placing a bet that that country will beat all other markets - a scenario that not only would be hard to forecast with any levels of accuracy, but would also happen at the expense of lost diversification.

Still this remains commonly in practice. Why? One driver for investing locally may be a person wanting to avoid currency related risk from investing abroad. To that, the Professor says, there are remedies: “There are institutional investors like pension funds and asset managers  who cheaply limit currency risk through currency hedging contracts." Another reason may be wanting to invest in ‘Swedish companies’ because a person has a lot of good information. This is a common belief but ignores one important reality - whatever information is out there, it is also available to millions of professionals across the globe using sophisticated tools to evaluate those exact companies. “It is important to remember that someone is always on the other side of the trade. A professional, a hedge fund manager,” the Professor says. Naturally people are not professionals and are unlikely to make a bargain in those cases. Instead they often end up sacrificing diversification and ultimately perhaps the only ‘free lunch’ out there.

 

Is There Ever a Reason Not to Fully Diversify?

It seems that diversification is a rule of thumb in investments for households, but is there ever a reason to diversify less? There is a situation, the Professor says in which a person should think about perhaps not fully diversify their portfolio, - hedging. Assume a person wants an apartment in Sweden in the future and their savings are directly aimed at that target. In that case, investing in the Swedish index and in companies that track the development of the Swedish real estate market could be a good strategy. Due to the fact that if the real estate market goes up, so will savings, and vice versa if the market drops. In the latter case, savings will be worth less but at the same time housing will be cheap. Another case could be not wanting to fully diversify in relation to one's labour income. “If a person works in banking they might not want to buy finance stocks since if the sector goes down, and they get fired, or receive less bonuses, also their savings will go down,” the Professor says. 

Nonetheless, both cases still stand in a trade-off with diversification. By not fully diversifying a person will always take some idiosyncratic risk and the correlation needs to be strong enough to justify concentrating savings, the Professor concludes. If not, they might, in fact, miss out on a perfectly - free - lunch.