What is a Free Lunch?
A free lunch refers to a situation where there is no cost incurred by the individual receiving the goods or service being provided. In the world of investing, free lunch usually refers to riskless profit, which has been proven to be unattainable for any extended period of time.
- A free lunch refers to a situation where there is no cost incurred by the individual receiving the goods, or service, being provided.
- A free lunch's cost is opportunity cost.
- In the world of investing, free lunch usually refers to riskless profit, which has been proven to be unattainable for any extended period of time.
Understanding Free Lunch
It is patently intuitive that a free lunch cannot exist, or if it is occurring, then it is only a matter of time before it is cut off. It refers to a situation in which a good or service is received at seemingly no cost because the expense is passed along to someone else or is obfuscated. Saloons in the 1800s sometimes offered a free lunch to patrons who kept ordering drinks as a way to bring in more business. This is partly how the saying made its way into common parlance.
A free lunch in investing cannot exist because of the constant trade-off investors make between risk and reward. The greater the inherent risk in an investment, the greater the reward. This is a fundamental truism. Conversely, securities with less risk generally have commensurately lower returns. So, the notion of riskless reward is, for the most part, a theoretical concept that provides fodder for academic discussions. On the rare occasions when this does occur, it will quickly be snuffed out by arbitrageurs who, by their actions, eliminate the inefficiencies that gave rise to the free lunch.
Perhaps the most conservative investment is U.S. Treasuries, which many consider to have such a small risk of default that it’s considered to be almost nonexistent. Few expect the U.S. government to ever go belly-up, or renege on its debt obligations. However, Treasuries cannot be considered riskless. They can decline substantially in value if demand wanes, or if the supply dramatically increases.
Moreover, Treasuries tend to pay fairly paltry yields, and often rise significantly in value 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 the potentially higher returns of riskier investments, such as investment-grade credit, commodities, futures, and equities.
Given that Treasuries are often a safe haven in times of uncertainty, they tend to rise when stocks are under severe pressure. For this reason, many investors utilize them as a hedge, or as part of a diversified portfolio. But this cannot eliminate portfolio risk completely, which, once again, validates the argument against the existence of a free lunch.
When a Free Lunch isn't Free
Investors must remain particularly wary of a seemingly free lunch when dealing with annuity investments that promise a stream of fairly high, fixed payments over a period of multiple years. Many of these investments remain laden 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 with no principal at the end of the term.
Also of note, some brokerages heavily marketed mortgage-backed securities as a seemingly free lunch in the early 2000s. These investments were described as being very safe, AAA-rated investments, backed by a diversified pool of mortgages. However, the housing crisis in the U.S. exposed the true underlying risk of these investments, as well as a faulty ratings system that classified pools of loans as AAA, even when many of the underlying loans carried very substantial default risks.