You’ve heard of Style Box investing, right?

Today, with the help of Morningstar and Kiplinger’s, you have the ability to set up a broadly diversified asset allocation if you can understand that picking one fund from each of the asset class style boxes below is how you would achieve around market returns for those categories.

There are 5 asset classes to choose from:

1. Cash
2. Bonds
3. Stocks
4. Real Estate
5. Commodities

Style Boxes split stocks and bonds (your two main investment firm categories) into broad diversification types:

Now, notice that Mutual Funds are not one of the five asset classes.

Yet almost all of us own mutual funds if not everywhere, then at least in our 401k. In fact, some investors we see own the same 20 funds in all 5 or 6 of their different investment accounts; Like a joint account with a husband and wife, two IRA’s from a former Company 401k, and 2 Roth IRA’s for example.

Then each of the funds will have anywhere from 30 or 45 positions, up to 500 or 2000 individual investments in them. We’ve recently seen portfolios with 1 and 3 million dollars in them, with over 90,000 positions because of this duplication and diversification.

Think about this: If $1,000,000.00 / 90,000 = 11.11 then if you double your money in a stock from 11.11 to 22.22 you basically have enough for a sandwich or an ok-to-crappy-salad instead of a TV or a car. That does not sound like the intention of investing to me.

What this means is that if you’re engaged in Style Box investing, you could be way too over diversified. These allocations, along with your mutual funds, have you diluted to the point of never being able to beat the market, and take advantage of what could be significant opportunity in individual equities.

Is the above broad diversification the only thing you need? And is broad diversification all you want?

In fact, in his ground-breaking study, How Many Stocks Make a Diversified Portfolio professor Meir Statman shows us that diversification benefits diminish greatly after the 10th stock, to where the 11th through the 11,000th make almost no discernible difference.

It also shows that the range in portfolio performance, or risk magnitude, or total dollars lost, or standard deviation, during a 3, 4, and 5 standard deviation event can be worse with more stocks, if they are concentrated in a particular sector, like tech stocks or bank stocks.

This is what happened in 2000 and 2008. The market went down near 50% n 2000-2—3 but Tech stocks went down 80%. In 2007- 2009 the market went down 57% and funds with a heavy weighting in banks were down 70% or more.

Take a look at Professor Statman’s graph illustrating his and our point:

We’ve zeroed in on the area where the line flattens and the Standard Deviation at 10 stocks is about 23 and 20/100-1000 is at about 19.

What The Heck Does This Mean?

In an event where the stock market goes down, it can be codified as a 1, 2, 3, 4, or 5 standard deviation event. It’s like the Richter Scale for Earthquakes or the Fujita Scale for Tornados. This is a very complicated term, that even some financial advisors don’t really grasp well. The following table helps to put it into perspective.

Hypothetical example is with a $1,000,000.00 portfolio:

In 2007 – 2009 Bill Miller’s Legg Mason Value fund lost 70%, while the S&P 500 lost -57% and the 30 stock Dow Jones Industrial Average lost -53%. So, more was less and less was more.

This does not prove less will be more for you, but what it does prove is that you don’t need all that diversification, as it will not protect you when you need it most. Only not being a part of a crashing asset class will help prevent loss in that asset class. And the only way to not be in a crashing asset class is to sell out early before the crash gets too large. This means selling high.

Traditional Since 1987, Not Forever.

This is difficult to hear and understand because we’ve been led to believe that the way things are commonly done, (or traditionally done now for 30 years since David Swenson of Yale endowment fame introduced us to style box investing) is the way they have always been done, and thus should continue to be done.

This is the classic definition of the appeal to tradition fallacy.

That means we believe that because an old way of thinking was prevalent, it was necessarily correct - that the past justifications for a tradition are still valid at present. In reality, the circumstances may have changed; this assumption may also therefore be untrue, or just be untrue anyway.

Don’t Be Fooled!

Indexes, sectors, funds and ETFs are organizational constructs that make diversification, and selling a lot of products, easier for investment firms.

They’re not the Ten Commandments of investing that will condemn you to hell if not followed. In fact the only way to be potentially better off is to NOT STRICTLY follow the style box method.

There’s more to the story – read on about the risks of Style Box investing here.