There is no free lunch in economics. This is a phrase that we hear quite frequently. It simply means that even if we do not pay for the lunch ourselves, we have still consumed scarce resources in eating it and someone else usually bears this cost. But in the context of portfolio management there is an exception to this rule.
Instinctively we know that we shouldn’t put all of our eggs in one basket because if we drop the basket we risk breaking all of our eggs at once. This is advice that our grandmothers’ might have given us. Equally, most would agree that investing all of one’s wealth in the equity of one company would in general be a riskier thing to do than to spread that wealth by investing in the equity of many companies.
The work of Professor Modigliani in the 1950s and other pioneers of modern portfolio theory showed that by spreading one’s wealth across a range of investment opportunities, investors could enjoy an elusive free lunch. Mr Modigliani and his colleagues proved that by constructing portfolios with assets that were imperfectly correlated with one another, the portfolio risk would decline as the number of assets within the portfolio increased. This reduction in risk (volatility) could be traced to these imperfect correlations.
However, these pioneers also showed that there were limits to these benefits, that is, limits to the quantity of this free lunch that one might be able to consume. Although a certain amount of risk could be reduced, virtually costlessly, as the portfolio became larger and larger, each additional security reduced risk by less and less. More recently, researchers have found that for portfolios of equities this limit lies somewhere between 30 and 40 stocks. In other words, a randomly chosen 40-stock portfolio would be as volatile on average as a randomly chosen 100-stock portfolio.
In a recent paper we put the theory of diversification to the test, but in the context of alternative investing. We asked the following question: is there a limit to the benefits of diversifying across a range of alternative asset classes and strategies?
We began our experiment by choosing a representative group of investments that included all those strategies and asset classes that one might term as being ‘alternative’, including private equity, infrastructure, hedge funds, commodities and foreign currency. From this group we created thousands of portfolios consisting of 2-23 of these alternatives that were randomly selected by the computer.
By the time eight alternatives were combined randomly, around 40% of the risk (measured by volatility) had been eliminated, but only a further 4% had been eliminated by combining 12 alternatives. Each additional alternative reduced volatility by less and less. Our research showed that the difference in volatility between a portfolio consisting of 10 alternatives and one comprising 20 was negligible.
Our results showed then that there is a free lunch available from investing in a range of alternatives, but that this free lunch was virtually fully consumed once the portfolio consisted of around 8-10 of these.
So that’s the theory. But what about diversification in practice? Many pension funds that diversified their portfolios away from UK equities by increasing their holdings in overseas equities and in some of these alternative asset classes and strategies were very disappointed by the events of 2008 when most of these asset classes fell in value together.
But we should not give up on the idea of diversification. For example, the average hedge fund did suffer losses over 2008, but this average loss was far smaller than the fall in the value of most global equity markets over the same period. So investors would have been better off on average from investing in a combination of equities and a diversified portfolio of hedge funds than if they had left all of their wealth in one equity basket.
This may not give a great deal of comfort to those pension fund trustees that had bought in to the idea of diversification. But a free lunch isn’t necessarily going to be as tasty as one prepared by Gordon Ramsay.
Andrew Clare is professor of asset management at Cass Business School and chairman of Fathom Financial Consulting.
