Why Diversification is the Only Free Lunch in Finance

By: Gridline Team | Published: 11/03/2022
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3 minutes

“There’s no free lunch” has been a mantra of finance for nearly a century. The Fed came to that realization as they watched $13 trillion in money printing lead to the inevitable: Persistently high inflation.

The mantra applies equally to investment portfolios. For instance, higher-return assets typically come with higher risk or longer investment horizons. As investors, we have to take what the market gives us.

As Nobel Prize laureate Harry Markowitz is reported to have said, however, “diversification is the only free lunch” in investing. Diversification is a time-honored way to manage risk. By spreading your investment dollars across a range of assets, you can smooth out the bumps of individual investments and earn higher returns without taking on additional risk.

Diversification in traditional markets

The iconic inventor of index funds, John Bogle, strongly advocates diversification. He famously said, “don’t look for the needle in the haystack. Just buy the haystack.”

Bogle’s point is that it’s impossible to know which stocks will outperform in the future. So, rather than picking individual winners, investors are better off diversifying across a range of stocks. This way, they’ll capture the market’s return.

Moreover, Bogle notes that “index funds eliminate the risks of individual stocks, market sectors, and manager selection.” Studies confirm that stock picking and timing are poor strategies for outperforming the market.

Diversification in alternative assets

Since the days of Bogle, financial markets have become much more complex. And, as we’ve seen in recent years, traditional assets can experience large declines. The critical role of diversification has only become more apparent.

Today, investors face 40-year-highs in inflation alongside consistently low bond yields. The Economist notes that “young people stand to make dismal returns” on their investments. In short, the traditional 60/40 portfolio that has long served investors is no longer up to the task.

Investors need to look beyond traditional assets to find returns in today’s environment. This often means investing in alternative assets, such as private equity, venture capital, cryptocurrency, and real estate.

While individual venture capital investments can be risky, diversifying across a number of these deals can offer significant upside potential with limited downside risk. This is because startups have a very high rate of failure, to the point that, out of ten angel investments, just one or two provide most of the return, with a 10-30X return expected on these investments.

Simply put, it’s a numbers game. By diversifying across several deals, investors find more of these “home runs,” with the probability of a positive return increasing as the number of investments increases.

The caveat

The observant reader will notice a couple of caveats to this story. For one, it only works if the assets are uncorrelated.

Venture capital and private equity are asset classes with low correlation to the public markets. In other words, when the stock market is down, these asset classes often perform well. This makes them ideal diversifiers in a portfolio.

The second caveat is that alternative assets are not always easy to access or invest in. For instance, venture capital and private equity require significant minimum investments and are difficult to access. Further, many Special Purpose Vehicles (SPVs) add risk. And, as we’ve seen with real estate, some markets are challenging to get into without large sums of money.

Gridline’s digital wealth platform solves these problems. It provides a curated selection of professionally managed alternative investment funds and enables access for individual investors and their advisors to gain diversified exposure to non-public assets with lower capital minimums, lower fees, and greater liquidity.

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