More than one way to get a free lunch

Nobel laureate Harry Markowitz famously called diversification “the only free lunch in investing.” His point was straightforward: combining different, uncorrelated sources of return can improve outcomes while reducing overall risk.

- Chad Padowitz, co-chief investment officer, Talaria

But in equity markets, diversification means more than simply holding a wider mix of assets.

Traditional equity returns are largely driven by market direction, earnings and changes in valuation multiples. The volatility risk premium (VRP) is different. It stems from something more fundamental: investors’ dislike and discomfort with uncertainty. In practice, this means investors are willing to pay for protection against adverse market moves, so implied volatility tends to trade above realised volatility over time.

For disciplined investors, that creates an opportunity to systematically harvest the insurance premium embedded in that behaviour. It is worth noting that selling put options also provides exposure to the equity risk premium — the compensation investors demand for bearing equity market risk. While the VRP and ERP are distinct return sources, they are complementary, and a disciplined strategy seeks to ensure investors are being adequately compensated for both.