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:
- The Stock market always moves up in the long term, but returns move up and down!
- Do not expect returns from mutual fund SIPs! Do this instead!
- What return can I expect from a 10-year SIP in the Nasdaq 100?
- Why should I invest in equity mutual funds when there is no guarantee of returns?
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.
🔥Secure your future with our Robo-advisory tool trusted by over 3,500 investors and advisors. From effortless retirement planning to funding your children’s biggest dreams, turn your financial goals into reality. 🔥
Subscribe for money management solutions via email! (Link takes you to our email sign-up form) Join 32,000+ readers in our community.
👉 New Tool Alert! NaviPlan: A Privacy-Focused Multi-asset Tracker and Goal Planner 👈
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.
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.
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
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.
The hybrid index is significantly and consistently less volatile. To finish off let us look at the 15-year rolling returns data.
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!
We are on Google News
Use this button to add freefincal.com as a preferred personal finance source on Google News.
Explore 1,400+ videos on YouTube!
Subscribe to get posts via email!
Join 32,000+ readers and get free money management solutions delivered to your inbox! (Link takes you to our email sign-up form)Join our WhatsApp Channel
Explore our products
🔥Join our community of 9000+ users! 🔥- Use our Robo-advisory Tool to create a complete financial plan! More than 3,500 investors and advisors use this! Use the discount code robo25 for 20% off. Plan your retirement (early, normal, before, and after), plus non-recurring financial goals (such as child education) and recurring financial goals (such as holidays and appliance purchases). The tool helps anyone aged 18 to 80 plan for retirement, plus six non-recurring and four recurring financial goals, with a detailed cash flow summary.
- Our Flagship Course! Learn to manage your portfolio like a pro to achieve your goals regardless of market conditions! More than 3,500 investors and advisors are part of our exclusive community! Get clarity on how to plan for your goals and achieve the necessary corpus no matter the market conditions! Watch the first lecture for free! One-time payment! No recurring fees! Lifelong access to videos! Reduce fear, uncertainty and doubt while investing! Learn how to plan for your goals before and after retirement with confidence.
- Join the freefincal investor circle! An exclusive space for investors, advisors, fintech employees and students to access financial planning and insurance tools, mutual fund and stock analysis tools, coding strategies and Excel macros for data extraction. 750+ members are now part of our investor circle.
- Increase your income by getting people to pay for your skills! More than 900 salaried employees, entrepreneurs and financial advisors are part of our exclusive community! Learn how to get people to pay for your skills! Whether you are a professional or small business owner seeking more clients through online visibility, or a salaried individual looking for side or passive income, we will show you how to do it by showcasing your skills and building a community that trusts and pays you. (Watch the 1st lecture for free). One-time payment! No recurring fees! Lifelong access to videos!
- Portfolio Tracker! Track your mutual funds and stock investments with our Google Sheet!
- We also publish monthly screeners for
Our Podcast: Let's Get Rich With Pattu
On Spotify: Let's Get RICH With PATTU! Every single Indian CAN grow their wealth! On Audible: Listen to the Let's Get Rich with Pattu Podcast
Listen to the Let's Get Rich With Pattu podcast on YouTube.
Now watch Let's Get Rich With Pattu தமிழில் (in Tamil)!About The Author
Dr M Pattabiraman giving a lecture
- Dr 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 14 years of experience publishing news analysis, research and financial product development. He has over 28 years of teaching and research experience. He is also a public speaker and keynote presenter.
- He is a patron and co-founder of “Fee-only India,” an organisation promoting unbiased, commission-free, AUM-independent investment advice.
- Connect with him via @pattufreefincal on X LinkedIn YouTube
- Pattabiraman has co-authored three print books.
This book helps you ask the right questions and find the right answers. It also includes nine online calculators to create custom solutions.
(2) Gamechanger: Forget Startups, Join Corporate & Still Live the Rich Life You Want. 
Both the boy and girl versions of "Chinchu Gets a Superpower".
Most investor problems stem from a lack of poor decision-making. We made bad decisions and money mistakes when we started earning, and we spent years undoing them. Why should our children go through the same pain? What is this book about? As parents, what if we had to groom one ability in our children that matters not only for money management and investing but for every aspect of life? My answer: Sound decision-making. So, in this book, we meet Chinchu, who is about to turn 10. The story follows what he wants for his birthday and how his parents plan it, while also teaching him key ideas about decision-making and money management. What readers say! 
Feedback from a young reader after reading Chinchu Gets a Superpower!
Must-read book even for adults! This is something that every parent should teach their kids right from a young age. The importance of money management and decision-making based on their wants and needs. Very nicely written in simple terms. - Arun.
About freefincal & its content policy
Freefincal is a News Media organisation dedicated to providing original analysis, reports, reviews and insights on mutual funds, stocks, investing, retirement and personal finance developments. We do so without conflict of interest and bias. Follow us on Google News. Freefincal serves more than three million readers a year (5 million page views) with articles based only on factual information and detailed analysis by its authors. All statements made will be verified with credible and knowledgeable sources before publication. Freefincal does not publish paid articles, promotions, PR, satire or opinions without data. All opinions will be inferences backed by verifiable, reproducible evidence/data. Contact Information: To get in touch, please use our contact form. (Sponsored posts or paid collaborations will not be entertained.)Our publications
- Your Ultimate Guide to Travel. This is an in-depth exploration of vacation planning, including how to find affordable flights, budget accommodations, and practical travel tips. It also examines the benefits of travelling slowly, both financially and psychologically, with links to relevant web pages and guidance at every step. Get the PDF for Rs 300 (instant download)
- How to profit from content writing: Our ebook is for those interested in getting a side income via content writing. It is available at a 50% discount for Rs. 500 only!