A leading 19th century art critic, social thinker and philanthropist, one of Ruskin’s lesser known legacies is his attribution to the phrase “There is no such thing as a free lunch”, a term those more worldly will recognise only too well. Just take the quite literal observations of Ruskin’s literary peer, Rudyard Kipling, on such an offer in a US saloon bar;
It was the institution of the "free lunch" I had struck. You paid for a drink and got as much as you wanted to eat. For something less than a rupee a day a man can feed himself sumptuously in San Francisco, even though he be a bankrupt.
On the surface, such a deal seems too generous to be true, indeed, the nourishment on offer was high in salt content (e.g. ham, cheese, and salted crackers), so those who ate them ended up buying a lot more drinks to quench their thirst. Such bars would also charge more for their beverages than their counterparts who were not offering accompanying food, resulting in a lot more being spent.
At a time when many are counting the cost of COVID-19’s devastating impact on the stock markets, some investors have, indeed, been enjoying something of a free meal, if not partly due to a number of restaurants and pubs signing up to the government’s “Eat Out to Help Out” scheme. This free lunch, it can be argued, has been in the form of strong portfolio diversification, a philosophy preached by investment pioneer, Harry Markowitz, in the 1950s. Branding it “the only free lunch in finance”, Markowitz’s work provided the mathematical foundations for portfolio optimisation, providing investors with an instrument where they could factor in the return they should expect according to the risk taken.
Put simply, diversification is an investment technique that reduces a portfolio’s overall volatility by allocating funds amongst various financial instruments, industries, and other categories. The aim is to smooth out price movements (up and down) through exposure to different areas that would each react differently to the same event. Still as valid a thesis as it was back then, although the menu and the restaurant may have changed, diversification continues to offer investors the opportunity to moderate their risk without sacrificing potential returns.
Although not a tool to avoid loss, a well-diversified portfolio can help evade the two main types of risk, Systemic and Non-Systemic. For example, if an investor held just shares in 1 or 2 companies, even ones to be perceived low risk investments, they could suffer heightened volatility if a certain event triggers a considerable “non-systemic” sell off, such as the Deepwater Horizon oil spill for BP or US Energy behemoth Enron folding due to accountancy fraud. The same principles also ring true for a “systemic” event that can affect the whole of the market, a topical example being the outbreak of COVID-19 and its effect on global stocks, causing most major indices to see contractions of at least 25% during March1.
With a portfolio consisting of not only companies that will be adversely affected by the resulting lockdown, such as the leisure industry, but also of ones that should benefit, such as logistics and purely online retailers, investors can reduce the volatility they face brought about by such events. Investing in typically lower risk assets, such as government bonds and gold, alongside riskier assets can also counteract bouts of market instability, justified by the fact US Treasury yields hitting all-time lows whilst gold climbed to record highs during a volatile spring/summer2.
Although during times of extreme market stress, such as the Global Financial Crisis, assets can begin to correlate with one and other as investors look to sell their best performing, liquid holdings, the perceived wisdom is that by not putting all your eggs in one basket, there is a something resembling a free lunch. The concept certainly provides food for thought for many investors as the COVID world looks set to continue for some time yet.
The information in this blog or any response to comments should not be regarded as financial advice. If you have any queries regarding this article, or your portfolio, please contact your Financial Planner. Past performance is not a reliable guide to the future. The value of investments can fall as well as rise and may be worth less than was invested. The information is based on our understanding in September 2020.