There are no “free lunches” there’s just “lunch or no lunch”
The Laws of Investing give everyone all they need to be successful investors just beware of the free lunch
As a young kid, my parents reminded me many times as probably yours did, that there were “no free lunches” and that nothing in life was just given to you. You had to earn it. It was a powerful lesson but probably lost on a teenager living and growing up with so many advantages “paid” for by my loving parents. Now with children of my own, as many of you too, the seriousness of this concept has made me even more aware that nothing is “truly” free and I need my kids to understand this as they go out into the world. Btw, your FB account is paid for, just not by you!
But it’s not just my kids who can benefit from this, I believe that getting our heads around “there is no free lunch” can also help us as investors focus on the most important themes that will make investing easier and more successful.
With what little I remember from my one time education in the sciences, there are immutable laws that govern the physical world. We touched on one in the last piece which was gravity and for those who remember high school physics, gravity anchors the Laws of Motion (think Isaac Newton) and life on earth as we know it, as well as the Laws of Conservation of Energy and Mass (think Einstein and E=mc2).
For every action there is an opposite and equal reaction and neither energy nor mass can be created or destroyed. No free lunches!
Still with me? In the investment world I hope I can convince you that there are also immutable laws and here they are: The Law of Time Value of Money and the Law of Diversification.
The Law of Time Value of money is the concept that deferring the use or access of that money in exchange for a return while another party has use and access of said money. Otherwise why would you do it? What would be the incentive for you to defer your use and your instant gratification?
Additionally, there is some risk that your money won’t be returned to you in partial or full in the future (this is where time comes in) then the compensation you will demand to “invest” this money, lose access and opportunity to spend, with this risk of default must go up
Put another way, its time away from your money that is the most critical part of investing. It’s the law! Straight to the point, given a long time to invest or the longest time possible to invest you will and must get paid and your investments will grow. But it comes at a cost and that cost is the deferred opportunity and access to use(spend) your money.
Voila! No free lunch!
But time and time again we see “investors” that are looking for ways to make money “faster” and without “risk”. In fact, its the norm not the exception and we hear and see it all the time. This may be controversial but whether its chasing performance or trying to tactically invest, its not possible to circumvent the law, there are no free lunches. Turning this concept upside down, in the investment world faster and less risky equals less return.
So what does this all mean? The best approach to investing is to use the one tool that everyone has, and it’s not Morningstar, Bloomberg or CNBC. It’s not the level of the stock market or the level of any other investment for that matter.
That’s right, it’s Time!
The biggest factor in investment success and financial freedom is not anything more than time and the second law of investing, diversification. So rather than looking for and being sold on the “free lunch”, a good investor needs to be maximizing over time the dollars they have to invest and maximizing the time those investments are “loaned” out. So one simple credo, though hard to execute, “Earn, Save and Invest…Early and often”. And it’s never too late and never too early.
Phew! We made it to here and not too much time taken.
The second immutable law of investing is the power of diversification, and its FREE!
Wait, I just told you that there are no free lunches. Ok, there is one free lunch and its diversification. But know that diversification is the exact opposite of what we see on Morningstar, Bloomberg, CNBC, the day trader next door or even our natural investing tendencies. Find the winners and sell the losers, buy only 5 star funds, follow the experts, time the market…many times its exactly these pursuits that concentrate our investment options and work against the power of diversification.
Diversification exploits the reality that risk and return are linked and the nature of volatility can be used to actually lower risk. Stay with me, in our earlier writing on volatility we stated that without volatility it would be impossible to get a return and now in this writing we have tried to prove that without time its also impossible to make a return.
Diversification, which is sort of like “not putting all your eggs in one basket” but it is more than that. It is the statistical fact and outcome that a collection of investments that have the same return potential but are not correlated in their interim price movements, if put together in a portfolio will deliver the same return potential but at a lower risk or volatility.
What this means is that when mixing one stock with other stocks, and as that stock or that investment is up or down, the others will be up or down differently. In plain speak, the combination of the stocks will have a lower volatility as the ups and downs will cancel each other out and exhibit lower risk than any one of the stocks alone.
Stating the Law of Diversification another way, the market will not reward any investor’s portfolio for risk taken that could be diversified away. And the great outcome is that we can build diversified portfolios and maximize the return paid to us and minimize the risk
This is commonly known as asset allocation and it does work. A portfolio of stocks and bonds for example will have dramatically lower risk than a stock only portfolio without the one to one corresponding loss in return. Free lunch!!
Back to chasing winners and basing all our investment decisions on performance. Buying only winners or past winners, or buying what everyone else is buying actually concentrates our investments in more similar names rather than diversifying our investments. Worse, is that in most cases those ‘winning” investments are performing for the same reasons and buyers of those investments are buying for the same reasons. Yikes
Finally, the perfect group of investments would then be actually those investments that are very uncorrelated(completely independent in their price movement) yet over time have positive return potential.
Even better, investments that are more negatively correlated in a portfolio deliver return and even lower risk more…So buying investments that are going down when others are going up would be a great way to lower risk in the portfolio. Maybe even deliver higher returns…but my TIME is up!
Two Laws that govern the investing universe and knowing these laws can make anyone a successful and impactful investor. Now time for lunch!
