The Free Meals of Investing

October 8, 2025

By Peter Mladina, Executive Director of Portfolio Research, Wealth Management

Investing has many sayings. Value investors say “buy low, sell high.” Long-term investors say “time in the market beats timing the market.” Prudent investors say “don’t put all your eggs in one basket,” which is a reminder to diversify investments to reduce risk.

It is often said that “diversification is the only free lunch in investing.” A free lunch serves up some benefit without sacrificing return or increasing risk. Most investment decisions are risk-return trade-offs, so they are not free. Diversification is a free lunch because it reduces risk without giving up expected return. But it is not the only free meal in investing.

Passive (index) investing is a free breakfast. The asset-weighted average fees for active U.S. large cap mutual funds and separately managed accounts (SMAs) are 0.54% and 0.61%, respectively. In comparison, the asset-weighted average fees for passive U.S. large cap funds (including exchange-traded funds) and SMAs are 0.06% and 0.10%, respectively.¹ Do the higher fees of active management come with a reliable risk-adjusted excess return (alpha)? The evidence says no. In our research article “Manager Performance and Persistence,” we evaluated the performance of all U.S. stock funds going back to 1973 and found no evidence of true (non-random) alpha net of fees. Exhibit 1 shows the average alpha from that study is -1.3% and the percentage of top-performing funds that produced statistically significant alpha (2.9% of funds) is slightly less than the percentage we would expect to find by random chance (3.0% of funds).²

Exhibit 1 – Alpha Prevalence

Additionally, active management usually comes with higher turnover, which typically results in higher taxes for taxable investors. Passive investing offers higher returns net of fees and taxes, without increasing risk—a free meal.

As previously noted, diversification is the free lunch. Correlation measures the strength and direction of how two assets co-move. A portfolio’s volatility risk (standard deviation) is reduced when combining assets and asset classes that are imperfectly correlated. The resulting portfolio’s standard deviation is less than the weighted average standard deviation of its underlying assets.

In our research article “Focused Equity Portfolios are Under-Diversified,” we formed stock portfolios of different sizes from S&P 500 constituent stocks and calculated their standard deviations. Exhibit 2 shows that larger portfolio sizes (more stocks) have lower risk, and by extension, better risk-adjusted returns (efficiency).³ This works when forming portfolios from underlying securities or from broad asset classes. Diversification reduces total portfolio risk without giving up expected return—a free meal.

Exhibit 2 – Diversification Benefits

Investors who fund liabilities or lifetime goals (e.g., consumption, gifts, etc.) have a free dinner: asset-liability matching. They can fully to partially secure a liability (goal) with little to no risk by constructing a liability hedge with their bond allocation. By employing high-grade bonds and aligning the duration of the bond allocation with the duration of the liability, the investor significantly reduces liability-relative risk (tracking error to the liability). Duration matching mitigates interest rate risk while high-grade bonds minimize default risk—the two key risks that can undermine liability funding. Tracking error manifests through time into dispersion in future funding outcomes (i.e., future surplus/shortfall), which is the risk that really matters to investors with liabilities or goals.

Exhibit 3 is an update to our research, “A Note on Securing High-Priority Goals”, that shows an example of asset-liability matching when funding a series of 10-year level annuities with either cash or a liability hedge.⁴ Cash (Treasury bills) is commonly viewed as the safe asset due to its minimal volatility. However, its liability-relative risk is significant due to a duration mismatch relative to the liability. The graph shows significant dispersion in funding outcomes when using cash to fund the series of annuities. In contrast, the portfolio of high-grade, duration-matched bonds shows minimal dispersion in funding outcomes through time. Asset-liability matching reduces liability-relative funding risk without giving up expected return—a free meal.

Exhibit 3 – Asset-Liability Matching

Most investment decisions are risk-return trade-offs, not free meals. However, passive investing, robust diversification and asset-liability matching are free meals because they offer either higher net returns or reduced risk without giving up anything. There are potentially other free meals, but most of these deal with tax efficiency and planning. For example, utilizing tax-favored accounts and asset location (i.e., locating tax-inefficient assets in tax-favored accounts), tax-loss harvesting (in some circumstances), and wealth transfer strategies (though these deal with reducing estate/gift tax, not investment tax per se) are potentially free meals because they reduce the overall tax burden, resulting in increased after-tax return with the same amount of risk. Investors should eat their free meals.