This Is The Only Free-Lunch In Investing
A simple guide to the two types of investment risk
Nobel laureate Harry Markowitz famously said that diversification is the only free lunch in investing.
Using stocks as an example, what he means is that buying the entire stock market—rather than a handful of individual stocks—tends to give investors a higher expected return without taking on excessive risk.
The higher returns, without greater risk, are the ‘free lunch,’ and diversification may indeed be the only free lunch. Typically, risk and returns are tied at the hip; you can’t expect to earn higher returns without taking on more risk.
But with diversification, you can expect better returns while actually reducing risk.
To understand how you need to know the two types of investment risk, we are going to get a bit nerdy.
There are two types of risk investors have to be aware of
Systematic risk.
Idiosyncratic risk.
Again, I’ll use the example of stocks to illustrate the two types of risk.
Systematic risk is the risk that the entire stock market will experience a downturn.
Anyone investing in the stock market is exposed to this risk at all times. But, investors accept this risk because the expected outcome is that stock prices go up over time. This is where the term “no risk, no reward” comes from.
Idiosyncratic risk is the risk that an individual company or a specific sector faces.
If you invested in an ETF focused on technology stocks, you would be exposed to the broader stock market risk and risks that are specific to the technology industry.
If you invested in a single stock, you would be exposed to the broader stock market risk and risks that are specific to that individual company. Think of a scenario where you had all your money in a single stock, and it comes to light that the CFO of that company had been engaging in financial fraud—that’s an extreme example of idiosyncratic risk.
The good news is that we can eliminate Ideological risks through proper diversification.
By proper diversification, I mean investing in broad-based index funds that are diversified by asset class and geography (more on that later. If your goal is to maximize risk-adjusted expected returns, broad-based index funds make much more sense than investing in specific industries or individual companies.
If you just want to learn the basics of why diversification is important, you can stop reading here.
But if you want to get a bit nerdy and dive into the research and theory behind diversification and ‘buying the whole market,’ keep reading.