NTL2009 said:
A scenario where a prudent person would lose all their money due to prudent stock market exposure, would be an extreme one.
Well, if they would have lost all their money, it's hard to describe it as prudent. It's hard to do this on a cash basis anyway (but with margin and leverage it gets easier). But that's not the risk.
The risk is not waking up one morning to find the stock market is at zero. The risk is overspending your savings.
Suppose you need $50,000/year for 15 years, and stocks went up 10% per year. Then you need $370,000 in savings. This number is low, because $37K of the needed $50K comes from growth, so you only need to spend $13K of principal.
Instead, suppose in the first year stocks are down 30%, then down 10%, then up 10%, then eight years at up 20% before returning to 10% per year. Over 15 years, this is more favorable than the straight 10%. So what happens?
You go broke in Year 7.
In that first year you lose almost half your money - the one-two punch of falling valuations plus having to spend a (proportionately) large chunk of principal. You never recover from this. If you want to make it through this scenario, you need to start with $540,000, not $370,000.
Suppose instead we had half our money in stocks and half in cash (0% change every year), and every year adjust so that this remains true. At $370,000, our nest egg lasts until Year 11 in both scenarios. This is more predictable - e.g. lower risk. If you want to make it to Year 15, you need to start with $490,000 in the flat 10% scenario and $450,000 in the market crash scenario. (Yes, they have reversed positions) This is why diversification reduces risk.
You could also have a pure cash solution, which would of course have zero stock market risk. That would take $750,000; at $370,000 you go broke in Year 9.
A final argument for diversification. A $450,000 portfolio would not make it through the market crash scenario if it were invested either in all stocks or all cash. But it does make it through on a 50-50 mix.