Most investors appreciate the idea of diversification, even if they steer clear of it. The idea is to limit volatility by investing in assets across different markets. If the assets are not correlated (meaning the rise or fall of one asset class is not linked to the rise or fall of another asset class), then diversification helps minimize the volatile swings that can happen when markets rise and fall.
How important is limiting volatility to your returns? If you’re anything like me, seeing is believing:
Increased volatility (higher highs and lower lows) greatly influences the average compounded investment returns. That means that, although the average return in Case A is the same as in Case F, Case A actually produces almost double the gain of Case F.
These numbers remain consistent even if you adjust the years in which the returns fall. For example, respective yearly returns of 18 percent, -10 percent and 10 percent produce the same returns as 10 percent, 18 percent, and -10 percent (or any other combination thereof) over a three-year span.
