There is saying “there’s no such thing as a free lunch” offers a lesson in life and economics.
Even if something appears free, the inescapable realities that goods are scarce, and you must make a choice, mean that there’s always a cost – opportunity cost. This concept was first popularised by Nobel Laureate Milton Friedman, in his 1975 book, “There’s No Such Thing as a Free Lunch.”
Harry Markowitz, another Nobel Prize winning economist, had a different perspective. Markowitz said: “Diversification is the only free lunch in investing.” Diversification, when done right, allows investors to achieve the maximum level of return for a given level of risk. This is the “free lunch” that Markowitz referred to.
We propose that there’s another free lunch that was overlooked by these great minds. We will get to that later, but first, let’s discuss diversification.
Free lunch #1: Diversification
Diversification is a simple concept. Let’s say you have a portfolio of just one company – a mining stock Rio Tinto. If Rio Tinto performs poorly, say due to falling commodity prices, then your portfolio is going to be hit hard.
Now let’s introduce a second company. For the sake of discussion, this company is equally as risky as the first, but it’s exposed to different risks. Let’s say this second company is a Xero which is a tech stock. When the first stock downgrades due to falling commodity prices, your second company is unaffected.
This imaginary portfolio, while still containing only stocks with equally high risk, just reduced its exposure to company-specific risk.
This concept can be expanded to add more and more shares, so that any one company’s performance ends up having only a small impact on overall portfolio performance. It’s not just limited to shares though – you can add bonds, commodities, or even different currency exposures to further diversify your risk. This is the basis for Modern Portfolio Theory* – which is what our friend Harry Markowitz won his Nobel Prize for.
Free lunch #2: Lower fees
0.75% per annum doesn’t sound like a lot, does it? Even on a $100,000 portfolio, that works out to just $750. That couldn’t make a big difference over the long term, or could it?
Well, yes. It could. While compounding interest is a great benefit when it works in your favour, it can also be a great detriment when it works against you. Based on a hypothetical example of a $100,000 portfolio with a 4% p.a. return over 20 years, a 0.75% p.a. fee reduction (from 1% to 0.25%) results in almost $30,000 difference!
While there’s no way to guarantee higher returns in investing, seeking products with lower fees can have a strong impact on overall portfolio returns. And unlike returns, fees are something that investors can control!
How to get low fees and diversification
In theory, this is really awesome but in practice, where can low fees and broad diversification be found? This where the real value of financial advice. With the expertise, resources & knowledge we can bring these two free lunches together for you.
If you are serious about making your investments work to optimum capacity, you should talk to us by calling 1300 861 143 or email email@example.com.
Stu Varidel and Your Choice Financial Planning Pty Ltd trading as Heart Financial Advisers are authorised representatives of Sentry Financial Services Pty Ltd AFSL (Australian Financial Services Licence) 286786.
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