Yes, Virginia, There Is a Free Lunch for Smart Investors

Being afraid I went and hid thy talent in the earth…. And his lord, answering, said to him: “Wicked and slothful servant!”
– Parable of the Talents, Matthew, 25: 14-30.

Life Itself Is a Free Lunch.

There's No Such Thing as a Free Lunch

It has come to my attention that there are noisemakers about disturbing the good people with talk that there is no free lunch. What? No free lunch? That changes everything!

It would change everything if it were so. It isn’t so. Don’t be impressed that there are lots of otherwise smart people who go along with this one. It’s an idea just about as dumb as it appears to be when you first hear it.

The idea that there is no free lunch comes from economists who use it to explain that actions that appear positive on first impression may bring about unintended and undesired consequences. Say that Congress were to adopt price controls in an effort to slow down inflation. That might cause a black market in the goods subject to the price limits, making it harder for people without access to the black market to obtain things they need. It is true that the appearance of a free lunch is often an illusion. Life is often a matter of weighing pros and cons; policy options that offer all upside and no downside are rare.

The problem is that the injunction against believing in a free lunch has been applied in contexts in which it does not apply. I argue in articles at this site that you can reduce the risks of owning stocks while also increasing the returns you obtain from stocks by adjusting your allocation in response to big swings in prices. My critics have argued that I am claiming to have discovered a free lunch and have rejected the idea as a logical impossibility. People are disputing what I say! Something must be done!

The reality is that free lunches are all over the place. Exercise is fun and yet it also improves your health and reduces your weight. It’s a free lunch. Falling in love increases your energy and stirs you to noble acts of selflessness. It’s a free lunch. Taking a hot bath on a cold winter day puts a smile of satisfaction on your face without requiring you to wait in any lines or find parking spaces. It’s a free lunch.

Life itself is a free lunch. You never paid for a ticket, did you? To reject any good thing you happen to discover on grounds that to believe in it would be to believe in a free lunch is morose madness. The entire trip is a free lunch, for heaven’s sake. Come on.

What happens in these sorts of cases is that someone comes up with a phrase that does a good job of summing up an important insight, it becomes popular as a result, and then over time people begin applying the insight in all sorts of inappropriate ways. There are indeed often hidden costs to decisions. Proposed actions are often not as positive as they at first appear to be. It makes sense to be wary of the idea that seems to promise a free lunch. It is madness, however, to reject the idea of a free lunch out of hand. Free lunches do exist and free lunches are wonderful. Finding free lunches is what the game of life is all about.

Rewards Given to Those Making Smart Investing Decisions Are Not Properly Thought Of as Being a Free Lunch.

Investors who change their stock allocations in response to dramatic price swings earn the roast beef sandwich they are paid as a reward. Those extra returns (at reduced risk) are not a free lunch. They are compensation for a job well done.

A Safer and Less Risky Way to Invest
Those changing their stock allocations in response to price changes are evidencing intelligence. It is proper and fitting that intelligent investing should pay off better than non-intelligent investing. It’s crazy that some today (this article was posted in December 2007) doubt this. It’s because those who doubt it are holding a weak hand that they feel compelled to bring in claims about lunches always coming with a price tag attached.

The no-free-lunch argument aims to unsettle those employing common sense when developing their investing strategies by suggesting that they are relying on wishes and dreams and desires rather than old-fashioned common sense. I suspect that those who deny that there are rewards for investing in a valuation-informed way turn to the no-free-lunch argument because it makes their own emotion-rooted strategies (the idea that prices might not affect returns has no support either in common sense or in the historical stock-return data) sound a bit more tough-minded than they would without benefit of this tough-sounding but inappropriately applied argument.

Those Arguing That There Is No Free Lunch for Smart Investors Are Counting on One of Their Own.

The idea that valuation-informed strategies are not rewarded is rooted in the Efficient Market Theory (Boo! Hiss!). This widely influential theory argues that there is no benefit to applying intelligence to investing choices because all of the thinking that could possibly do any good has already been done by others and factored into the prices of any stocks you might buy.

Um, right.

The Efficient Market Theory is the granddaddy of free-lunch claims. According to this theory, the wildest gambler who ever lived, the guy who falls for every story-stock claim that comes down the pike, can never make a bad call. If intelligence has no effect on investing results, the lack of intelligence cannot have any effect either. If you believe in the Efficient Market Theory, you believe that there is no possibility of anyone making a bad choice. The price is always right. Risk is always properly rewarded.

I believe that there is such a thing as a free lunch. But I don’t believe in ridiculous things. There are limits. Smart investors obtain better results than the other kind. There is no magic efficiency in the market that transforms our bad decisions into acceptable ones. There is a free lunch for those who earn it. And there is a fall into a pool of icy cold water for those who come to believe in the Efficient Market Theory and require a dramatic wake-up call.

The Force Will Not Be With You If You Do Not Accept the Free Lunch Given to Smart Investors.

New Economic Ideas

I view the Efficient Market Theory as a truly dumb idea. But that’s the least of it. What I really believe is that it is an evil idea. An evil idea. I’m not joking.

Look at the words from the Parable of the Talents quoted at the top of this article. I don’t get the sense that Jesus thinks we should be failing to make use of our investing insights on grounds that there is no thing as a free lunch. Do you?

It’s one thing to lack intelligence. If you lack intelligence, you should exercise prudence and caution in investing. I don’t consider myself the sharpest knife in the drawer re a lot of the questions that come up in InvestoWorld in the year 2007. So I exercise a good bit of caution and prudence myself. I consider it no sin to do so.

However, I would consider it a sin to turn off my brain to the extent that I would need to turn it off to persuade myself that my common sense and intelligence can in no circumstances be used to inform my investing decisions. What did God give me a brain for if not to make use of it? If I turn off my brain, I have sent God back his gift unopened. I have committed the sin of ingratitude.

You don’t need to be a Christian to relate to what I am saying here. My sons listen to Star Wars movies more often than is good for them. The background noise that I hear while writing the articles that appear at this site often refers to “the Force” and the importance of having it be with you. I think it would be fair to say that those failing to make use of common sense and intelligence in forming their investing strategies do not have the Force working with then. The Efficient Market Theory is an investing theory from The Dark Side. I think it would be fair to question whether it is a matter of pure coincidence that there is no photographic evidence showing Eugene Fama and Darth Vader having ever been present in in the same room at the same time.

Stocks Themselves Constitute a Free Lunch.

The free-lunch argument is employed to mock those who believe that it makes sense to apply common sense and intelligence to the investing project. Amazingly, the argument is usually put forward by people who purport to be pro-stock. Is it pro-stock to argue that stock investing must be mindless to be effective? It sure doesn’t seem so to me.

It is anti-stock argument. Consider this. If it really were so that common sense and intelligence could never provide an edge, would it not follow that those who use their common sense and intelligence to learn to invest in stocks rather than alternative investment classes are seeking an impossible free lunch? It follows.

Successful Investing

Stocks provide long-term returns superior to the returns provided by most other asset classes. Stocks constitute a free lunch. Those who deny the possibility of a free lunch deny the possibility that stocks could offer as good a long-run investing proposition as the historical data shows they really do offer.

The Efficient Market Theory is a theory rooted in fearfulness. People don’t see it that way because this is a theory that gained popularity during a wild bull market. The deep reality, though, is that to turn away from your own common sense and intelligence is to make a statement that you lack confidence in your ability to make your way in the world. Those who follow this philosophy of investing stand defeated in their own minds before they begin their efforts.

It Pays to Be Skeptical of An Apparent Free Lunch.

The no-free lunch idea would never have become so popular if there were zero truth to it. What is true is that things that seem too good to be true often are not true. It pays to be skeptical of an apparent free lunch. It’s when you come to believe that all exercises of common sense and intelligence are fruitless that you know that you have gone over the edge.

A Small Free Lunch Is a Big Deal.

Never let the significance of the compounding returns phenomenon stray too far from your consciousness. There are many ways to gain a small edge in investing. It is rare to identify something giving you a big edge.

A small edge is plenty. The compounding returns phenomenon transforms a small edge into a very large amount of dollars over the course of an investing lifetime. Please check out the Investor’s Scenario Surfer to see how investing in a valuation-informed way gives you an edge that will likely permit you to achieve financial freedom a good number of years sooner than would otherwise be possible.

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