Why is diversification the only free lunch in investing?


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.

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!

 

Do share this article with your friends using the buttons below.


🔥Enjoy massive discounts on our courses and robo-advisory tool! 🔥


Use our Robo-advisory Excel Tool for a start-to-finish financial plan! More than 1000 investors and advisors use this!


New Tool! => Track your mutual funds and stocks investments with this Google Sheet!



  • Do you have a comment about the above article? Reach out to us on Twitter: @freefincal or @pattufreefincal
  • Join our YouTube Community and explore more than 1000 videos!
  • Have a question? Subscribe to our newsletter with this form.
  • Hit ‘reply’ to any email from us! We do not offer personalized investment advice. We can write a detailed article without mentioning your name if you have a generic question.

Get free money management solutions delivered to your mailbox! Subscribe to get posts via email!


Explore the site! Search among our 2000+ articles for information and insight!

About The Author

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 nine years of experience publishing news analysis, research and financial product development. Connect with him via Twitter or 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.


Our flagship course! Learn to manage your portfolio like a pro to achieve your goals regardless of market conditions! More than 3000 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 what the market condition is!! Watch the first lecture for free!  One-time payment! No recurring fees! Life-long access to videos! Reduce fear, uncertainty and doubt while investing! Learn how to plan for your goals before and after retirement with confidence.


Our new course!  Increase your income by getting people to pay for your skills! More than 700 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 who wants more clients via online visibility or a salaried person wanting a side income or passive income, we will show you how to achieve this by showcasing your skills and building a community that trusts you and pays you! (watch 1st lecture for free). One-time payment! No recurring fees! Life-long access to videos!   


Our new book for kids: “Chinchu gets a superpower!” is now available!

Both boy and girl version covers of Chinchu gets a superpower
Both boy and girl version covers of Chinchu gets a superpower.

Most investor problems can be traced to a lack of informed decision-making. We have all made bad decisions and money mistakes when we started earning and spent years undoing these mistakes. Why should our children go through the same pain? What is this book about? As parents, what would it be if we had to groom one ability in our children that is key not only to money management and investing but to any aspect of life? My answer: Sound Decision Making. So in this book, we meet Chinchu, who is about to turn 10. What he wants for his birthday and how his parents plan for it and teach him several key ideas of decision making and money management is the narrative. What readers say!

Feedback from a young reader after reading Chinchu gets a Superpower (small version)
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 their young age. The importance of money management and decision making based on their wants and needs. Very nicely written in simple terms. – Arun.

Buy the book: Chinchu gets a superpower for your child!


How to profit from content writing: Our new ebook for those interested in getting side income via content writing. It is available at a 50% discount for Rs. 500 only!


Want to check if the market is overvalued or undervalued? Use our market valuation tool (it will work with any index!), or you buy the new Tactical Buy/Sell timing tool!


We publish monthly mutual fund screeners and momentum, low volatility stock screeners.


About freefincal & its content policy Freefincal is a News Media Organization 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 from credible and knowledgeable sources before publication. Freefincal does not publish any paid articles, promotions, PR, satire or opinions without data. All opinions presented will only be inferences backed by verifiable, reproducible evidence/data. Contact information: letters {at} freefincal {dot} com (sponsored posts or paid collaborations will not be entertained)


Connect with us on social media


Our publications

You Can Be Rich Too with Goal-Based Investing

You can be rich too with goal based investingPublished by CNBC TV18, this book is meant to help you ask the right questions and seek the correct answers, and since it comes with nine online calculators, you can also create custom solutions for your lifestyle! Get it now.


Gamechanger: Forget Startups, Join Corporate & Still Live the Rich Life You Want Gamechanger: Forget Start-ups, Join Corporate and Still Live the Rich Life you wantThis book is meant for young earners to get their basics right from day one! It will also help you travel to exotic places at a low cost! Get it or gift it to a young earner.


Your Ultimate Guide to Travel

Travel-Training-Kit-Cover-new This is an in-depth dive analysis into vacation planning, finding cheap flights, budget accommodation, what to do when travelling, and how travelling slowly is better financially and psychologically with links to the web pages and hand-holding at every step. Get the pdf for Rs 300 (instant download)


 





Source link