Nobel laureate Milton Friedman is generally credited with stating, “There’s no such thing as a free lunch.” Actually, if you know what you are doing, you can get a free lunch in investing. Unfortunately, most investors get stuck with very expensive meals.
Diversification is a free lunch
Diversification is a free lunch. It basically refers to the concept of not putting all your eggs in the same basket.
There are major benefits of holding a diversified portfolio. Obtaining these benefits costs you nothing. Author and blogger Mike Piper recently explained the benefits of diversification. He correctly explained the likely returns from a basket of only five stocks are extremely unpredictable. That’s because of what is known as “idiosyncratic risk,” meaning risks unique to a particular stock.
Lots can go wrong when you hold just a few stocks. Common examples include embezzlement, natural disasters and expropriation.
You can mitigate idiosyncratic risk through diversification. In addition, you gain a level of predictability regarding returns. As Piper notes, your returns are unlikely to be either spectacularly high or spectacularly low, which is a prudent way to structure a long-term portfolio.
The cost of putting together a diversified portfolio is low and getting lower. Fidelity and Vanguard are currently engaged in a price war. Fees on low-cost index funds and exchange-traded funds (ETFs) have never been lower. The average net expense ratio of Fidelity’s index funds is now only 0.102 percent. Fees on its ETFs are even lower. They are now 0.084 percent, which are currently the lowest in the market.
It has never been easier to own a globally diversified portfolio of low-cost index funds or ETFs in an allocation suitable for you. This is a free lunch. You owe it to yourself and your loved ones to take advantage of it.
A laddered bond portfolio can be a free lunch
Most investors would be better served by owning bonds in a low-cost, high-quality, short- or intermediate-term bond index fund. However, for investors with $1 million or more to invest in bonds, a properly structured laddered bond portfolio can be a free lunch.
My colleague, Larry Swedroe, set forth the requirements for putting together a laddered bond portfolio in this blog. He noted that it’s possible to assemble a bond portfolio with higher-quality bonds (and therefore less risk) than comparable bond funds, at a lower cost. It is also possible to purchase FDIC-insured CDs (which mutual funds cannot purchase) with higher yields than comparable Treasury bonds but no greater risk (since both are backed by the full faith and credit of the U.S. government).
Investors who don’t have large bond portfolios can take advantage of this disparity by buying these CDs instead of Treasuries. Obtaining higher yields with no greater risk is the essence of a free lunch.
Sticking to your investment plan is a free lunch
The precipitous drop in the markets, followed by a rapid recovery, after the Brexit vote was announced illustrates why so many investors don’t take advantage of another free lunch.
When there is a crisis in the market, the financial media often turns to “experts” to explain to the rest of us “what is going on.” Their opinions often vary widely, contributing to investor anxiety.
One economist declared that Brexit would have no lasting impact on the market. Historian Antony Beevor disagreed, noting ominously that “the danger is that Britain suddenly pulling out of the European Union at such a moment of crisis … could pull the whole thing down.”
Investors who panicked suffered meaningful losses when the market recovered.
Investors who have an investment plan in place pay little attention to market gyrations. They understand stocks go through negative periods. Their asset allocation permits them to weather the storm. They stay focused on their long-term goals. They understand that market prices are set by millions of traders viewing publicly available information every minute of every day. The possibility of any “expert” uncovering something missed by the collective wisdom of these traders is highly unlikely.
The ultimate free lunch is ignoring much of the financial media and staying focused and disciplined. It costs you nothing. The benefits in higher expected returns are significant.
This commentary originally appeared July 12 on HuffingtonPost.com
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