Broad diversification and lower volatility can result in a higher compound return and greater eventual wealth.
In this example, while Portfolio 1 posts a strong gain in the first year, this is more than eliminated in the second year. By contrast, Portfolio 2 experiences a much smaller gain and subsequent loss during the 2-year period. But its lower volatility produces a higher compound return and preserves more portfolio value.
Managing volatility is particularly crucial during a market downturn. After experiencing a loss, a portfolio must earn an even higher return in future periods to fully recover its previous level.
Diversification is the key investment tool used to manage and reduce volatility.
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