What is a free lunch?
A free lunch refers to a situation where there is no cost incurred by the person receiving the goods or services that are provided. In the investment world, free lunch generally refers to risk-free earnings, which have been shown to be unattainable for an extended period of time.
- A free lunch describes a situation in which a person receives goods or services at no cost.
- The cost of a free lunch is the opportunity cost.
- In terms of investment, a free lunch is usually a risk-free profit.
Understanding free lunch
It is evidently intuitive that a free lunch cannot exist, or if it is happening, then it is only a matter of time before it is interrupted. It refers to a situation in which a good or service is received seemingly at no cost because the expense is transferred to another person or is confused. Salons in the 19th century sometimes offered a free lunch to customers who kept ordering drinks as a way to generate more business. This is in part how the saying found its way into common parlance.
There cannot be a free lunch in investing because of the constant trade-off that investors make between risk and reward. The greater the risk inherent in an investment, the greater the reward. This is a fundamental obviousness. In contrast, securities with less risk generally have proportionally lower returns. Therefore, the notion of reward without risk is, for the most part, a theoretical concept that fuels academic discussions. On the rare occasions that this happens, you will be quickly stifled by arbitrageurs who, with their actions, eliminate the inefficiencies that led to the free lunch.
Perhaps the most conservative investment is in US Treasuries, which many consider to have such a small default risk that it is considered almost non-existent. Few expect the US government to collapse or fail to meet its debt obligations. However, Treasuries cannot be considered risk-free. They can decrease substantially in value if demand decreases or if supply increases dramatically.
Additionally, Treasuries tend to pay rather negligible returns, and often their value increases significantly only during periods of severe economic uncertainty. For this reason, there is an opportunity cost to investing in Treasuries. That is, investors in Treasuries miss out on potentially higher returns on riskier investments, such as investment grade credit, commodities, futures, and stocks.
Since Treasuries are often a safe haven in uncertain times, they tend to rise when stocks are under heavy pressure. For this reason, many investors use them as a hedge or as part of a diversified portfolio. But this cannot completely eliminate portfolio risk, which, once again, validates the argument against free lunch.
When a free lunch isn’t free
Investors should be particularly wary of a seemingly free lunch when it comes to annuity investments that promise a fairly high fixed payment stream over a period of several years. Many of these investments are still loaded with fees, some of which may not be fully understood by investors. In general, any investment that promises a guaranteed return is not a free lunch. Also, unlike bonds, annuities leave investors without capital at the end of the term.
Also noteworthy is that some brokerages heavily marketed MBS as a seemingly free lunch in the early 2000s. These investments were described as very safe, AAA-rated investments backed by a diversified pool of mortgages. However, the housing crisis in the US exposed the true underlying risk of these investments, as well as a flawed rating system that classified groups of loans as AAA, even when many of the underlying loans had very high default risks. substantial.