08/26/2025
This is NOT Real Diversification!
This may get me in trouble with the Kool-Aid drinkers.
Let's talk about something that you will see from 95% of financial advisors: portfolios built by building up style boxes. You know the drill - large-cap value, small-cap growth, mid-cap blend, international, and so on. 10 boxes in total. It looks diversified. It checks all the boxes - literally. But here's the thing: that's not what Modern Portfolio Theory was meant to be.
THE STYLE BOX POLICE
The investment world likes using style boxes because they're simple and look good in marketing. But these boxes don't really connect to Modern Portfolio Theory (MPT). Economist John Cochrane (not OJ's attorney) says: "I don't even know what these names mean. As a finance professor, they don't make much sense to me."
MPT says that investors should have their investments spread out over asset classes that are not correlated to one another. Meaning, they don't move together, particularly during down markets. It allows more risk averse investors the ability to participate in the markets during the upturns, but with a mode of protection during the downside. Think stocks paired with bonds, commodities, real estate, currencies, and other alternatives.
If you just follow the style box method advocated by most advisors, you would be primarily in two asset classes - stocks and bonds - all of the time. The stock style boxes tend to be highly correlated to each other, particularly in downturns. And while bonds can provide a level of protection, it has usually come with little to no market performance. And in the more recent downturns, has actually become more correlated with stocks.
But again, this method is just easy for most advisors to implement without any thought.
These style boxes make fund mangers stick closely to the market instead of trying to build truly diverse portfolios. One expert explains: "We criticize managers when they change their style. We expect them to stick to their plan...Even when we chose them for their talent, we really want them to copy the index."
FOCUS ON WHAT MATTERS
Nobel Prize winning Economist Harry Markowitz didn't write about style categories. He wrote about relationships - specifically how assets interact. His goal wasn't to build portfolios that look balanced. It was to build ones that are balanced. And balance, in this context, means mixing assets that don't all move the same way at the same time. In other words, the assets are lowly correlated.
"A good portfolio is more than a long list of good stocks and bonds. It's a balanced whole," Markowitz said. That idea - balance through low correlation - is at the heart of true diversification. Not labels. Not grids.
Somewhere along the way, though, advisors and investment firms GOT LAZY. Or maybe just too comfortable. Style boxes made it easier to explain portfolios to clients. THey made it easier to package products. And yes, they made it easier to sell. But in simplifying the story, it also simplified the process - too much.
The result? Portfolios that look diversified on paper but really aren't. You can own five funds in five different style boxes and still be loaded with the same underlying exposure, high correlation, and concentrated risks - just dressed up in different clothes.
William Sharpe (another Nobel Prize winner), who gave us the Sharpe ration (a measurement of manager skill), didn't talk about style boxes either. He talked about efficiency - getting the most return for a given level of risk. "The reward-to-variability ratio is what matters," he said. Not balance by category. Balance by behavior.
SO WHAT SHOULD A PORTFOLIO DO INSTEAD?
Here's where technology actually helps. A good portfolio optimizer doesn't care about style boxes. It doesn't care if you've got the right "blend" of value and growth. What it does care about is how each asset interacts with the others. Correlation, expected return, volatility - that's what it runs on.
This is how I create and rebalance portfolios for clients - portfolio optimizers.
When used properly, an optimizer helps build portfolios the way Markowitz imagined. Feeding realistic inputs - returns, risks, relationships - and it helps map out combinations that make sense for the actual goal: more return for the appropriate level of risk. It does the math so I can do the thinking. BASED ON CORRELATIONS.
I don't have to guess or hope the boxes cover all angles and are all checked. I see how the pieces fit together - or don't. I can stress test exposures. I can run scenarios. I can make smarter choices, not just prettier charts.
Style box allocation is a diluted version of real portfolio theory. It's a shortcut - one that's more marketing than math. And it's time we moved on from it.
I owe my clients better than grids and guesses. Let's build portfolios that work under the hood - not just look good on the brochure.
I'm here to help you work through these opportunities and make sure your investment plan stays focused on your long-term money goals. Please feel free to contact me to talk about your specific situation.
👉 Call 215-962-3744 or book a chat here: https://calendly.com/neshaminycreekadvisors/30-minute-call
Best,
Patrick
Neshaminy Creek Advisors
215-962-3744
[email protected]
www.neshaminycreekadvisors.com
PS This is about as deep as I get in regards to how the sausage is made. Most of my clients are not interested in how the sausage is made, just that, like real sausage, it's consistent(ish).
