The Free Lunch Syndrome

free lunchFree lunch syndrome is a time wasting disease prevalent across all sectors of business. 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.

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. 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.

Unsecured Finance

Unsecured loans are not a free lunch. In fact qualifying for unsecured loans is far more difficult than qualifying for a collateral based loan. In business financing, residential real estate, and many other sectors, a slang term for a potential customer who is unlikely to be approved is a tire kicker, and we have all met them. They waste our time. As do dreamers. These are people who wake up in the morning and say to themselves, ‘I wish I had millions of dollars to start a terrific business’. Again, time wasters looking for a handout or a free lunch. They are identified easily by the way they present themselves. Often times they are all knowledgeable, believing that an investor owes them something, or that investors are sitting in their office on a pile of cash waiting for their call. In truth they do not and do not wish to understand the process. Ideas and dreams are not fundable.

 


 

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