The Only Free Lunch in Finance

Amar Pandit , CFA , CFP

This post builds on the most important subject of last week’s post “Bullshit Your Way to a Million Dollars.” If you recollect the subject, Kudos to you. If you don’t, I would encourage you to read the previous post. To the impatient ones, here it goes – Risk.

Risk as a subject is rarely understood by investors. Let’s take a typical scenario in Investing.

We fill in the risk tolerance questionnaires of financial professionals in a cold state (stock markets are calm). Things are going great. Then the markets go ballistic on the upside. We pay no attention or might take even more risk than we can understand. Why? Because everyone is making quick money and there is free flowing bullshit everywhere. Then the markets correct and crash. We enter a different hot state and once again have no process or framework to make rational decisions. We fear. We panic. Some press the panic button despite the known fact that risk goes down when the stock markets go down or when the price of any sound asset goes down.

In his book “The Most Important Thing”, Howard Marks wrote, “Investing consists of exactly one thing: dealing with the future. And because none of us can know the future with certainty, risk is inescapable. Thus, dealing with risk is an essential element in investing and in life (I added the last 3 words). It’s not hard to find investments that might go up. But you are unlikely to succeed for long if you haven’t dealt explicitly with risk.

The first step consists of understanding it. The second step is recognizing when it’s high. The critical final step is controlling it.”

While these are golden words, let’s first understand the origin and meaning of the word “Risk.”

Allison Schrager writes some phenomenal gems about Risk in her book “An Economist Walks into a Brothel.

She writes, “When people hear the word risk, they automatically think of something terrible, the worst-case scenario, like losing a job, or their wealth. But we need to take risks to make our lives better. If we want to get ahead at work, we have to volunteer for projects that we might fail at. If we avoid risk, our lives won’t move forward. Technically risk describes everything that might happen- both good and bad- and how probable each of these outcomes is.

Even the history of the word “risk” illustrates our complicated feelings about the concept: it derives from rhizikon, an ancient Greek seafaring term that describes a dangerous hazard. But the meaning changed in the sixteenth century, when exploration of the New World began, and people started to think of risk as something controllable- not left to fate. The Middle High German word rysigo means to dare, to undertake, enterprise, hope for economic success.

Whether we realize it or not, you take risks large and small, every day, in all parts of your life.”

We think of risk in a very simple way and binary way. If we invest in the stock market, we might lose money, or we might gain money. But the fear of losing money is so high, that many don’t even try to understand this risk. They simply stay put with fixed deposits or bonds despite losing their purchasing power and even in many cases outliving their money.

Allison adds further, “We are often taught to think of decisions in terms of “if I do X, then I will get Y,” but in reality, any time we make a decision, a range of Ys could happen, from a superior Y to a terrible outcome. Once we recognize this, we can take steps to alter the range of Ys. We can’t guarantee a positive outcome, but when we think about risk more strategically, we can increase the odds that things will work out. This is called taking a calculated risk.

The question then becomes how do I take calculated risks in Investing?

This is where the only free lunch in finance comes in.

When you invest in the stock market, you face 2 kinds of risk – Systematic and Unsystematic (This is one of those few times when I am rattling off some technical stuff, but I promise to keep it simple).

Unsystematic or Idiosyncratic Risk is the risk of a single stock going up or down. Systematic Risk on the other hand is about the entire market going up and down. You can reduce unsystematic risk but there is nothing much you can do about Systematic Risk (remember you have to embrace this- Amor Fati Volatility). Unsystematic Risk on the other hand is avoidable and this is done by diversifying the portfolio across more and more companies. Diversification loses its meaning beyond a certain number of stocks or funds, but the fact is that you can reduce or even eliminate Unsystematic Risk simply by having a solid diversified portfolio. And this by the way is the only Free Lunch in Finance – Higher Expected Returns and Lower Risk.

And by Diversification, I don’t mean Naïve Diversification such as diversifying across financial professionals or buying 50 mutual funds or listening to 5 different people or thinking PMS means diversifying. If you happen to practice some naïve form of diversification, you would have turned the only free lunch in finance into a pretty expensive one.