Most investors understand that markets move up and down. What’s less obvious, but far more important, is how losses impact your ability to recover. This is where the law of large losses becomes one of the most valuable concepts in long-term investing.
If you had $100 and it fell to $50 (a 50% loss), you would need a 100% return just to make that $50 back.
This simple example highlights a truth many investors overlook:
recoveries require disproportionately larger gains.
And once you grasp that, the importance of diversification becomes much clearer.
When Losses Get Too Big, Two Forces Work Against You
1. The Maths Turns Against You
Losses compound in reverse:
- A 25% drop requires a 33% gain to recover
- A 50% drop requires 100%
- Larger losses grow exponentially harder to claw back
This is why concentrated bets can be so damaging. The deeper the hole, the steeper the climb.
2. Your Behaviour Gets Tested
But the math is only half the challenge.
The psychological impact is often even greater.
Large drawdowns:
- Hurt confidence
- Make you question your strategy
- Tempt you to pause contributions or sell at the wrong time
These periods can feel like standing still for years. And it’s often during those moments of doubt that investors abandon their plan — locking in losses and missing the recovery.
The Role of Diversification: A Behavioural Advantage
Diversification isn’t about eliminating volatility , that’s impossible.
It’s about controlling the size of any single loss, financially and emotionally.
A concentrated position means every movement feels like it’s happening to your entire portfolio.
A diversified portfolio spreads that impact, allowing you to:
- Invest more of your wealth with confidence
- Avoid catastrophic drawdowns
- View losses in context rather than panic
- Stay committed even when individual assets struggle
The real wealth killer isn’t volatility , it’s when a large loss hits your entire portfolio.
Diversification ensures that doesn’t happen.
It’s Not About Avoiding Losses, It’s About Understanding Them
Losses are a normal part of investing. They will always occur, and they will sometimes be uncomfortable.
The goal isn’t to avoid them completely.
The goal is to understand:
- What role each risky asset plays
- How it fits into the bigger picture
- How to size positions so no single outcome can derail your journey
Perspective is power. And diversification provides that perspective.
The Real Driver of Long-Term Wealth
The most important factor in building wealth over decades isn’t the market itself. It’s your ability to stay invested long enough for compounding to work.
And staying invested is far easier when no single investment has the ability to shake your confidence.
That’s the true purpose of diversification:
to keep investors in the game long enough to win.