Why is diversification the only free lunch in investing?

Published: July 17, 2023 at 6:00 am

Last Updated on July 17, 2023 at 7:32 am

A reader has asked us to explain why diversification is the only free lunch in investing with some India-centric data. As the name suggests, free lunch refers to some benefits without a catch, fee, or cost. There is no free lunch in nature. Can there be one in investing?

What does “Diversification is the only free lunch in investing” mean? Consider a 100% equity portfolio. Needless to say, this is highly risky. But what does high risk refer to? It means the range of future returns over the short or long term will be too wide for comfort.

There is no point expecting 15% from such a portfolio when long term returns can range from negative to positive. For some data, see:

So that is the reason we say do not put all your eggs in the same basket – at least not in equity because the uncertainty is too much, and the risk can become unmanageable.


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Suppose we replace, say, 35% of the equity with bonds. The resulting portfolio is significantly less volatile on a day-to-day basis, the spread in returns is lower, and the return itself is not significantly lower than a 100% equity portfolio.

So just replacing some stocks with bonds, the risk decreases significantly, but the return does not decrease as much. This is the “free lunch” being referred to. It is a win-win situation.

If one were to manage this portfolio on their own, then each time there is a rebalance, there is a tax incidence, so there is a cost, although much smaller than the benefits. If one uses an aggressive hybrid fund, this cost is removed, but one will have to pay the fund management fees. So technically, it is not a “free lunch”, but the benefits are large enough to deem it so.

Let us now look at some data. We shall compare Nifty 500 TRI with a hybrid index comprising of 65% Nifty 500 TRI and 35% IBEX gilt index from Jan 1995 to April 2023.

Evolution of Nifty 500 TRI and 65% Nifty 500 + 35% Gilts Hybrid Index from Jan 1995
Evolution of Nifty 500 TRI and 65% Nifty 500 + 35% Gilts Hybrid Index from Jan 1995

One can immediately see from the above graph that hybrid index does well to keep pace with the equity index and from time to time outperforms.

The maximum drawdown is one way to measure risk. This is the fall from an all-time high. Once can also see how long a security has remained underwater from this graph.

Maximum drawdown 500 TRI and the 65% Nifty 500 + 35% Gilts Hybrid Index from Jan 1995
Maximum drawdown 500 TRI and the 65% Nifty 500 + 35% Gilts Hybrid Index from Jan 1995

It should be clear that the hybrid index has significantly lower drawdown than a 100% equity portfolio. However it should be kept in mind that the hybrid index is still an equity index and still  quite risky.

Next we look at4535 10-year return data points (rolling returns). It is easy to see that the spread (min – max return) is much lower for the hybrid index. Yes from time to time the 100% equity index outperforms but it quickly falls back down on the hybrid line

10-year rolling returns comparison of Nifty 500 TRI and the 65% Nifty 500 + 35% Gilts Hybrid Index
10-year rolling returns comparison of Nifty 500 TRI and the 65% Nifty 500 + 35% Gilts Hybrid Index

Another way to measure risk is to look at the volatility in the NAV as meausred by the standard deivation. This is the 10-year rolling standard deviation data.

10-year rolling volatility (standard deviation) comparison of Nifty 500 TRI and the 65% Nifty 500 + 35% Gilts Hybrid Index
10-year rolling volatility (standard deviation) comparison of Nifty 500 TRI and the 65% Nifty 500 + 35% Gilts Hybrid Index

The hybrid index is significantly and consistently less volatile. To finish off let us look at the 15-year rolling returns data.

15-year rolling returns comparison of Nifty 500 TRI and the 65% Nifty 500 + 35% Gilts Hybrid Index
15-year rolling returns comparison of Nifty 500 TRI and the 65% Nifty 500 + 35% Gilts Hybrid Index

In the last 15-years or so, aside from a brief window, the hyrbid index returns have been comparable to that of the 100% equity index.

Thus diversification results in a significant lowering of risk but not return. That is why it is know as the free lunch in investing. It is easy to imagine why it is the only free lunch because any other strategy always has a downside.

At freefcinal we have always heralded the importance of agressive hybrid fund in an investors portfolio. We recently pointed out why we badly need an aggressive hybrid index fund!

 

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Pattabiraman editor freefincalDr. M. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. He has over ten years of experience publishing news analysis, research and financial product development. Connect with him via Twitter, Linkedin, or YouTube. Pattabiraman has co-authored three print books: (1) You can be rich too with goal-based investing (CNBC TV18) for DIY investors. (2) Gamechanger for young earners. (3) Chinchu Gets a Superpower! for kids. He has also written seven other free e-books on various money management topics. He is a patron and co-founder of “Fee-only India,” an organisation promoting unbiased, commission-free investment advice.
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