A diversified investor is seeking the same dilemma. Do they stick with their traditional investment mix or do they introduce additional risk and volatility by swapping defensive assets for aggressive assets.

The approach we’ve taken is known as style drift. Normally when growth assets increase disproportionately in value, we would reduce these and buy more defensive assets- ensuring the portfolio reflects the investors risk tolerance. However over the past couple of years we’ve chosen not to do this. Instead we’ve allowed the growth components within portfolios to drift higher. This has proven to be very profitable.

However, your portfolio is now at a point where the investment mix is close to exceeding our tolerance for your risk profile.

The question is: do we tolerate this, knowing that the portfolio becomes more volatile as the growth component increases? Or do we sell shares and buy bonds (guaranteeing a negative return)?

Over the long term (7yrs+), I’m confident the increased volatility will be rewarded with significant outperformance (relative to bonds). However if the investor was to panic during the next correction and sell the growth assets, locking in what otherwise would have been a paper loss, then allowing style drift, would have been the wrong decision.

Investors need to understand their own tolerance for volatility.

Investors who are experienced, who have a long term investment time horizon and hold quality assets are generally better positioned to cope with the inevitable volatility.

It’s very important to understand what kind of investor you are because traditional diversification (cash and bond exposure) means accepting negative real returns for the foreseeable future.

Our portfolios have been very underweight bonds for a couple of years now. But rather than allocate extra funds to shares (high volatility), we’ve reallocated much of that traditional bond exposure to medium volatility assets (infrastructure, gold, property).

We expect these medium risk assets will have a lower correlation with shares and therefore provide some degree of dampening the increased volatility.

Regardless, risks are rising and investors need to decide whether they are comfortable enough to accept this.