No Free Lunches - Not Even Portfolio DiversificationJul 16, 2018

Key Points

There are few things in life that are truly free. That is, goods or services given to us at no cost without some associated liability either immediately, indirectly or down the line. Perhaps we could say the air we breathe is free, though we imagine there’s a carbon credit trader somewhere who could make an argument against that.

The bottom line is everything has a cost. We know this. It’s why we smile wryly when we get email from a Nigerian prince promising wealth beyond our wildest dreams for a “modest” up-front cash advance. Why we quickly hang up on robo-callers delivering the “great news” about our fortune in winning a vacation sweepstakes. And why, as asset managers, we know the notion that “diversification is the only free lunch” in investing is not entirely accurate.

Nobel Prize winner Harry Markowitz is credited with coining the phrase “diversification is the only free lunch in finance.” But there is no such thing as a free lunch (TINSTAAFL), even with portfolio diversification. 

Vikram Josyula

Vikram Josyula, CFA
Senior Risk Consultant, Multi-asset Strategies
Investment Risk Management Group


In this new topic paper from the Investment Risk Management Group, Vikram Josyula explains why portfolio diversification is often more challenging than some investors have been taught to believe. 
  1. Correlations are not stable—they drift … We see this empirically in the historical data we review, and we experienced it in real-time during the great financial crisis of 2008.
  2. Diversification is often presented as an oversimplified concept. On the surface a snapshot of assets may seem diversified, but if we take a deeper look—that is dive in at the risk factor level—we may find overlapping factor exposures that are correlated.
  3. Even underlying factors may move significantly together given different market regimes, especially during periods of heightened volatility

We suggest a true assessment of portfolio diversification and risk requires a holistic approach: seeking to build truly diversified portfolios is an exercise in both art and science. The science is in the data and tools we use—factor correlation matrixes, stress tests, factor composition analysis. The art is in the way in which the data is interpreted, and the people that do the interpreting.

While there may be no truly free lunches, the value of wisdom, experience and judgment can certainly offer some solid discounts.

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TINSTAAFL - Not Even Portfolio Diversification

Why portfolio diversification is often more challenging than some investors have been taught to believe. 

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Risk Management at Franklin Templeton
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