The concept of time diversification implies that investment risk decreases with time. Although it is true that the holding period standard deviation decreases with time, periodic standard deviation does not decrease with time, and the magnitude of the annual deviations in dollars increases with time, assuming that portfolios increase in value over their holding periods. In aggregate, these factors result in a very broad range of probable ending values for portfolios with long investment horizons. The term “time diversification” is probably a misnomer, but that’s what it’s called.
As they say, time is on your side, and in investing, it is, especially given the power of compounding. Time also makes it possible for you to recover from losses or periods of under-performance but, although recovery is possible, it’s not guaranteed. And as your investment horizon lengthens, the probable standard deviation of your long-term average return decreases, which is the effect of what is known as time diversification.
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