In Investing, There Is No Free Lunch

03/02/2012 04:05 pm ET | Updated May 02, 2012
  • Irene Aldridge Quantitative portfolio manager; MD at, speaker, author, 'High-Frequency Trading'

Many articles on the subject of money talk about different ways to invest the money: which stocks to pick, whether to choose bonds over stocks and Exchange-Traded Funds (ETFs) versus mutual funds. Few of the pieces, however, address the key issue underlying any allocation which may be keeping investors up at night: the implicit costs of placing their money into someone else's hands.

Any investment decision amounts to just that: transferring money into someone else's care. When purchasing stock of a particular company, an investor transfers his money to the management of the stock-issuing corporation with the sole hope that the management will take good care of the money and produce returns on investment through their business activity. When buying into a mutual fund, the investor entrusts the mutual fund managers to research and pick the best stock investing opportunities. When selecting government bonds, the investor implicitly transfers responsibility for taking care of the money to the government representatives.

In each of the above cases, the investor moves his money to other human beings whose job it is to take care of the investor's nest egg. And in each case, the people in charge of the money are subject to two human truisms:

1) They need to be paid to support their livelihoods.
2) They may or may not deliver expected investment results, despite their best efforts.

The compensation of professionals entrusted with investment responsibilities varies with the complexity of investments in their care and level of their expertise. With some investments, like mutual funds, the management compensation is bundled into a management fee, which often runs 1-2 percent of the money allocated to the investment manager. This management fee may be accompanied by the so-called performance fee, which the investment manager earns on the returns he provides for the investors. The performance fee can range from 10 percent to 40 percent of the returns! In the case of individual stock and bond investments, this management fee is bundled in with earnings of corporate and government officials overseeing the investments. Thus, in stocks, management compensation cuts into company's financials and the resulting stock returns. In bonds, management compensation is also priced in the lower rate of return.

The risk of poor financial performance is another fact of life. Even the most diligent and well-meaning investment managers face the positive probability of unpredictable events adversely affecting performance of money under their care. For example, an earthquake may wipe out factory facilities of a stock-issuing corporation, causing the stock prices to plummet. An unexpectedly bad turn of the economy at large can dampen sales and similarly handicap performance on multiple firms. A changing population structure may impact the financial soundness of a bond-issuing municipality. The uncertain future value of one's investments is known as financial risk. Over the years, various ways have been proposed to minimize financial risk, for example, through diversification of one's investments.

Despite the scientific advances in economics, financial and risk management, one thing remains as true and constant today as it did one hundred years ago: to achieve a higher return, the investor has to trade something in. An investor desiring to generate higher dollar returns on his investments either has to increase his investments (pay for the returns with more money), or buy the returns by incurring personal risk and potentially sleepless nights. Investors cannot get something for nothing. Even in investment management, there is no free lunch.