Investors: Can You Really Get Something for Nothing?
June 2011
Hint: Yes, But…
Who says there’s no such thing as a free lunch? The
famous free-market economist, Milton Friedman, to
name one, entitled his 1975 book with the expression.
And they’re generally wise watchwords. Take all those
“free” seminar/luncheons, for example—those “no obligation” offers to enlighten you on how to retire in
style (with variable annuities). Yeah, right. If you’re enjoying a meal, and the accompanying sales pitch promises minimal risk in exchange for a whole lot of reward,
odds are that you are the one who will end up getting
bitten.
Summary
Savvy investors know that one can never get
something for absolutely nothing. However, they
also know that there are key “low cost” (or low
pain) techniques that can help them optimize
returns. By making the most of diversification,
small-cap and value securities, beta, rebalancing
and reduced costs, investors can squeeze more
out of their portfolios without significantly
changing their risk exposure or expected returns.
But I’ve got some good news. While those not-sofree “free lunches” may be more prominently peddled, there are several solid blue-plate investor specials
available to anyone, and as close to a free lunch as it gets:
 Diversification
 Small-cap and value premiums
 Better beta
 Rebalancing
 Cost management
Diversification: Let Us Eat Cake
In my mind, the most sensible way to invest without losing your head over it is by diversifying your
investments, which helps to spread (and thus minimize) your risk within these two categories:
1. Market risk. Various academically defined asset classes in the market have demonstrated different risk/return characteristics; for example, stocks are considered generally riskier than bonds.
Market risk is inherent to investing, so no matter how widely your portfolio is diversified, you’ll
still be exposed to it in proportion to the amount of riskier investments held. Savvy investors
know this; they respect the potential damage and expect to be compensated for accepting the
risk. In a way, this is what investing is all about.
2. Idiosyncratic risk. There’s also security-specific risk, i.e., the risk that something bad will happen to a particular security you’ve purchased. Unlike market risk, idiosyncratic risk can be dramatically minimized through diversification. If one stock goes belly up but you’re diversified
across several hundred stocks, there’s far less damage done. The market knows this too, which is
why it offers no expected compensation for pursuing idiosyncratic risk.
Something for Nothing • June 2011 • pg. 1 of 3
877.481.7110 • www.rightpathinvestments.com
Other than referenced material © 2011 RightPath Investments & Financial Planning, Inc.
RightPath Investments & Financial Planning
Your Way to Prosperity
In other words, through diversification, you can: (1) manage market risk by diversifying across
riskier/less risky market asset classes, and (2) reduce idiosyncratic risk by diversifying into numerous
securities (typically using low-cost mutual funds).
Small-Cap and Value Premiums
Beyond diversification between stocks and bonds, there also are specific stock asset classes that offer increased or decreased market risk/reward.
 Small-cap stocks. Historically portfolios of small-company stocks have delivered higher returns
than portfolios of large-company stocks.
 Value stocks. Likewise, portfolios of companies that are out of favor (due to conditions such as
a higher debt load), have delivered higher returns than portfolios of favored growth companies.
By tilting your diversified stock portfolio toward these riskier asset classes of small-cap and value
stocks, you can expect the nearly free lunch of higher returns over the long-term. This can allow you to
allocate a smaller portion of your portfolio to stocks and a larger portion to bonds. The stock portion of
your portfolio will be essentially working harder for you, by being exposed to more concentrated
amounts of expected risk and reward.
You noticed I said “nearly free lunch.” It’s important to emphasize that expected market rewards
don’t come without increased exposure to real market risk. There are likely to be times, potentially long
and severe, during which these risks will be revealed and your risk-tilted portfolio will underperform the
overall market. This is known as tracking error, when your portfolio may not resemble the status quo.
Investors who fear they might succumb to tracking error by selling when things look bleak will do themselves more harm than good by seeking the extra returns to begin with. Thus, your nearly free lunch
must come with a side dish of caveat.
Better Beta
So far, we’ve focused on investment strategy. There’s also the matter of selecting fund managers to
implement it. How do you know if your funds are doing their job? You look at their beta, the measurement of how well a fund is capturing the returns to be had from the asset class(es) it is supposed to be
representing.
 Actively managed funds do the worst job, because their focus is not on achieving high beta. Instead, they chase “alpha,” which are returns above the appropriate risk-adjusted benchmark (i.e.,
above beta). If you’d like to read a good book about the fallacies inherent to this strategy, we
recommend Larry Swedroe’s The Quest for Alpha.
 Index funds are the most commonly known vehicle for seeking to capture beta. These aren’t a
bad choice. However, they seek to capture asset class returns in an indirect way—by tracking an
index that in turn tracks an asset class. This can generate a few inefficiencies, such as susceptibility to index reconstruction.
Choosing a Trustee • June 2011 • pg. 2 of 3
877.481.7110 • www.rightpathinvestments.com
Other than referenced material © 2011 RightPath Investments & Financial Planning, Inc.
RightPath Investments & Financial Planning

Your Way to Prosperity
Dimensional Fund Advisors (DFA) is distinct among fund companies in that it is the only manager of which I’m aware that directly tracks the asset classes themselves, with no index standing
between.
Reasonable Rebalancing
Once you’ve built your properly structured portfolio, the next free lunch comes in the form of periodically rebalancing your portfolio.
Even if you did nothing to your portfolio, as your various investments deliver their expected returns,
the original balance of your portfolio will change over time. For example, say you begin with a portfolio
that is half stocks and half bonds. Over time, stocks are expected to outperform bonds so eventually
you’ll be over-weighted in stocks and under-weighted in bonds.
Enter the free lunch of rebalancing. To return your portfolio to your desired 50/50 mix, you sell
some stocks and buy some bonds. What are you doing? You’re selling your high-priced stocks that have
been doing well, and purchasing low-priced bonds that have been lagging behind. Automatically selling
high and buying low? Sounds like a sensible strategy to me.
Cutting Costs
This one is pretty simple. All else being equal, choosing the lowest-cost way to invest according to
the above tenets is among the best free-lunch opportunities around.
Interestingly, while actively managed funds tend to do the worst job of delivering beta, they also
tend to be considerably more expensive than either index or DFA funds. Even within the universe of index funds, costs can range widely for essentially identical offerings, so it pays to comparison shop if
you’re going that route. Admittedly, some DFA’s funds have slightly higher expense ratios than their
index fund counterparts, but the trade-off of more accurately capturing your desired beta may still argue
in favor of DFA’s more efficient structure. This is one instance when an objective advisor can help you
perform an effective cost-benefit analysis.
Dining (and Investing) in Style
So, who says there’s no such thing as a free lunch? Clearly, there are plenty of get-rich-quick
schemes that can lead you astray in your investment activities. As always, if something sounds too good
to be true, it probably is—especially if it promises high reward for low risk.
For the prudent investor, there are still some good meal tickets to be had by constructing and maintaining your portfolio’s essential ingredients according to the tenets of sound investment strategy.
Choosing a Trustee • June 2011 • pg. 3 of 3
877.481.7110 • www.rightpathinvestments.com
Other than referenced material © 2011 RightPath Investments & Financial Planning, Inc.