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Let me start by saying that I don't believe that volatility is a proper measure of risk and this question is not about risk. However, this board seems the most appropriate place to ask this question.

I always believed that as a long term buyer and holder of a diversified portfolio of shares, the interim volatility doesn't matter. In other words, what matters is the value of my shares in 20 years' time when I will be cashing them for retirement. If there is a 50% stockmarket crash tomorrow, it's of no concern to me. I should invest in the asset class with the highest return and ignore the interim volatility.

Now let's say that I can invest in a choice of two portfolios for the next 3 years with the following returns:

Stocks: 50%, -41%, 50%
Property: 5%, 10% and 15%

An investment of $100 in either portfolio will rise to $ 133 after 3 years. Likewise an investment of $50 in both portfolios will also amount to £133 in total.

Now, consider what happens if I change my strategy so that at the start of each year, I rebalance my portfolio such that I have 50% of my portfolio in property and 50% in stocks. My portfolio will be much less volatile than the sole stocks portfolio as it will be evened out by property.

My annual returns are now 27.5%, -15.5% and 27.5%, so this mixed portfolio accumulates to $143 after 3 years.

I am leaving out the transaction costs in switching from property to equities and back again.

But my conclusion is that a more balanced portfolio which reduces the portfolio volatility will boost the overall returns.

Am I missing something ?

Brendan

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