Importance of Diversification
Diversification seeks to hedge against volatility in a portfolio with the intent that the positive performance of some investments will neutralize the negative performance of other investments.
To help minimize risk and volatility, we construct broadly diversified portfolios and seek uncorrelated return among asset classes. It is crucial to manage down-side risk through portfolio diversification because draw-downs and dramatic losses can take years to recover.
For example, an individual retires at the end of 1999 with $1,000,000 in retirement savings. Each year, $40,000 will be withdrawn from the portfolio for living expenses. The retiree will also need to account for 3% inflation each year.
By investing the portfolio in a diversified mix of stocks and bonds at the end of 1999, the value at the end of 2008 would be just shy of $700,000. However, by investing the same portfolio in 100% stocks at the end of 1999, the value at the end of 2008 would be a little less than $400,000. A portfolio invested entirely in stocks lacks the possible hedge against volatility that diversification can provide.