What is a Free Lunch
A free lunch doesn’t exist. It refers to a situation in which a good or service is received seemingly at 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.
In the world of investing, free lunch represents riskless profit, which also is not possible.
BREAKING DOWN Free Lunch
A free lunch in investing does not exist because of the constant trade-off investors must undertake between risk and reward. The more risk inherent in an investment, the more reward. Conversely, securities with less risk generally pay relatively less.
Perhaps the most conservative investment is U.S. Treasuries, which many consider to have such a small default risk it’s 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 for Treasury wanes, or the supply of U.S. Treasuries 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 of 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.
Because Treasuries tend to rise when the price of stocks falls, many investors utilize them as a hedge, or as part of a diversified portfolio. Still, it’s only one aspect of Treasury investments that are nearly risk-free.
Guarding Against the Seemingly Free Lunch
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 still 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 sold 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.