What it means
The saying is said to come from bars in the nineteenth century United States that offered free food to customers who bought drinks. The lunch was not truly free, because the price of the food was included in the cost of the drinks.
Economists adopted the phrase to express the idea that resources are limited and that every choice involves a trade-off. The trade-off is measured by opportunity cost, which is the value of the best alternative that is given up when a choice is made.
If a company spends $100,000 on one project, it cannot spend the same money on another. Good decisions weigh benefits against what has been sacrificed.
In investing, the principle shows up as the link between risk and return. Higher expected returns normally come with higher risk, so an investment that promises high returns with no risk should be treated with suspicion.
This is a common feature of scams and unrealistic sales pitches. There is one famous exception.
Diversification, which means spreading money across many different investments, can reduce risk without lowering the expected return by the same amount. For this reason, it is often called the only free lunch in investing, a phrase linked to the work on portfolio theory by Harry Markowitz.
Even diversification is not completely free, because it involves some cost in fees, effort and complexity. It also cannot remove all risk, as market-wide falls still affect a diversified portfolio.
The practical lesson is to look for the hidden price of anything that appears to be offered for nothing. A related idea in business is the so-called freemium model, in which a basic product is given away to attract users who may later pay.
The free tier is not charity, because the seller expects the cost to be recovered through upgrades, advertising or data.
In practice
Real-world examples.
Example
A marketing manager is offered a free tool to send emails to customers. After counting the hours needed to move contact lists and learn the tool, she finds it would cost more than a paid service that comes with support. She decides to pay for the service after comparing totals.
Example
An investor is promised a 25% annual return with no risk. Remembering that high returns usually come with high risk, he declines and later learns that the scheme collapsed. A quick search shows no regulated firm could promise such a result.
Example
A portfolio manager adds international shares to a portfolio of domestic shares. The mix lowers volatility without reducing expected returns by the same amount, which she describes to clients as the closest thing to a free lunch. Fees on the extra funds were small compared with the risk reduction.
Formula
Calculation
True cost of a free offer = time cost + training cost + switching cost + any other costs - cash price paid
Suppose a company is offered free project management software with no subscription fee. Setting it up takes 40 hours of staff time at $50 an hour, which is $2,000. Training costs $1,500, and moving old data costs $500.
True cost = $2,000 + $1,500 + $500 = $4,000, with a cash price of $0. The software is not free, and the company should compare $4,000 with the cost of paid alternatives.Case study
Seen in the real world.
Hollis and Dane Consulting is a fictional firm that was offered a free upgrade to its accounting software if it signed a three-year contract. The managing partner liked the sound of it, but the finance manager asked for a full costing before agreeing.
She found that the contract carried a price rise of 12% a year on support fees and a charge of $3,000 to leave early. In this illustrative case, the three-year cost of the supposedly free upgrade was about $9,500 more than staying with the current arrangement.
The firm negotiated a one-year term and a fixed support fee instead. The managing partner thanked the finance manager and started asking for a costing before every offer that sounded too good to be true. The managing partner also added a line to the firm's procurement policy requiring a three-year cost comparison for every contract with an introductory discount.
Watch out
Common mistakes.
- Counting only the cash price and ignoring time, training and switching costs.
- Believing that any investment can offer high returns without risk.
- Assuming diversification removes all risk, when it reduces only the risk specific to individual investments.
Questions
People also ask.
Where does the phrase come from?
It is said to come from nineteenth century bars that offered free food with drinks, which were priced to cover the cost. The idea is that nothing offered is ever truly without a price.
Is diversification really a free lunch?
Largely, because it can lower risk without a matching fall in expected return, but it still involves some costs and cannot remove market-wide risk. Costs such as trading fees and tax can reduce the benefit.
How does a free lunch relate to arbitrage?
A true arbitrage is a risk-free profit with no investment, which in efficient markets is expected to disappear quickly once traders spot it. Real arbitrage opportunities are rare and short lived.
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