I of course respect your call re that one, Dylan. The feeling is not mutual. I am grateful for your contributions and will continue to try to learn from reading them despite our different takes on a few issues. I am confident from reading your stuff here and elsewhere that there is much more re which we agree than there is re which we disagree. But I of course understand if you elect not to respond to my posts. And you of course have my best wishes in all your life endeavors regardless of your call on this one rather insignificant-in-the grand-scheme-of-things matter.

Rob

Perhaps, Dylan. It certainly is so that no two humans can ever understand each other perfectly.

But my sense from reading between the lines of your response to Mike is that you get the general idea. Questioning of the “there is no free lunch” idea is questioning of a premise of the Passive Investing model. I am in favor of such questioning and you are not so keen on the idea. I think that’s the difference between us, Dylan.

My belief is that we all are going to experience a giant leap forward in our understanding of how investing works when we get to the point where we are okay with questioning our starting-point premises.

Rob

Just for the record, I would say that.

I put in $100 and at the end of the year I have (on average) $106.50. That’s a free lunch, in my eyes.

It’s the product of economic growth. We don’t pay for economic growth. It’s just one magical aspect of this wonderful thing we call “Life.” This is why I often reduce my argument to the claim that “life itself is a free lunch.”

If there were no free lunches, there would be no growth, there would be no average return of 6.5 percent real. That’s a sort of gift that life gives us. We should be grateful. It’s as much a free lunch as picking an apple off a tree is a free lunch. We should be grateful for both the apple and the average return of 6.5 percent real, in my view. If these things were not available to us, we would sure notice the difference.

Rob

You certainly are not alone in thinking that investment returns come at the cost of taking on risk, Dylan. But this has never been proven in any scientific sense. It is a theory.

I do not believe that investors are being compensated for taking on risk. I believe that we are being compensated for permitting our money to be used to build productive enterprises.

There’s risk in that, to be sure. But the amount of risk that one must take on to earn X return is not fixed. There are all sorts of things that one can do to minimize one’s risk while not diminishing one’s returns. All of these things can be viewed as “free lunches” by those who think that only taking on more risk can generate a greater return. But, again, that’s a theory, not a proven reality.

Diversification greatly reduces risk. If I allow one company to use my money, I am taking on a chance that that one company will go bankrupt. When I buy an index fund (much more diversified), that risk is greatly diminished. I limit my upside by doing this (individual companies have the potential of generating returns far in excess of those generated by an index). It is fair to say that there is a cost of diversifying. But I believe that there is a free lunch element to this choice as well. The mix of upside and downside is much better for the individual investor making the choice that provides greater diversification (index funds).

I don’t believe that diversification is the only free lunch available to investors. I believe that there are lots of them. Every advance in our understanding of how investing works can be characterized as a free lunch. If we rule out free lunches, we are essentially ruling out ever learning anything new about how to invest effectively. I learn new things all the time. So I see little appeal in the idea of walking the “no free lunch” path.

Rob

Ah. Fair enough. No arguments there.

That’s the comparison that I’m making as well. And I don’t disagree with the concept that diversification costs nothing extra. I just don’t like to call it “free.” “free” and “no extra cost” are not the same to me.

If the lowest cost sandwich is $1, but that same sandwich can be bought for $2, $3, or $5. Buying the $1 sandwich is not a “free lunch.” Is just the best deal.

I think calling stuff like this a “free lunch” just adds fuel to the “diversification (or asset allocation, or buy & hold) does not work” zealots’ fire when a portfolio has a negative returning year despite being diversified. I can already hear their sarcastic inquiries, “where’s your ‘free lunch’ now?”

Rob, you have now idea what I am thinking. And I have absolutely no idea as to what in the world you’re thinking.

When people say diversification is a free lunch, the comparison is between a diversified portfolio and an undiversified portfolio with the same expected return and same level of market risk. (End result: Diversified portfolio has same expected return yet less risk. A free lunch.)

The comparison you’re making is between a diversified portfolio of risky assets and a (diversified? undiversified? does it matter?) portfolio of risk-free assets. (End result: Diversified portfolio has greater expected returns, but with greater risk. Not a free lunch.)

Or to say it differently, I can’t imagine that people would argue that holding equities (or other risky assets) is a free lunch. Just that if you’re going to hold equities, diversifying your portfolio among equities is a free lunch.

The “lunch” is market returns. The cost for diversification is market risk. That’s not free. Market returns without any risk sounds more like a free lunch to me.

For the non-diversified, there are additional costs (company risks, sector risks, underperformance risk, etc) for the same market return “lunch.” Yes, some non-diversified portfolios will return above the market, but for that to happen, others must return below the market equally.

There is no doubt that lunch costs more if you’re not diversified, but that doesn’t make diversification “free.”

It can be argued that anything and everything has the potential for an opportunity cost, and I agree with Mike that diversification has a negative net opportunity cost.