By Colin Nicholson

All investing involves risk. It cannot be avoided, but it can be managed. One of the more important ways to manage risk is through diversification.

Diversification at its highest level means that we invest in a number of different assets, which ideally do not all rise and fall at the same time. Thus, a private investor may split investment capital between property, stocks, bonds (fixed interest) and some cash. Stocks may be further split between local and overseas markets. Property may be further split into a residence, rental housing and commercial buildings and so on.

The next level of diversification is within each of those classes of assets. With any given type of property, the investor has a problem in that the assets are lumpy and small investors do not therefore have a great opportunity to diversify until their total capital grows considerably. However, with stocks, the issue is far easier in that it is simpler to buy shares in a number of companies. The companies chosen can also be in different industry sectors, providing further diversification.

The basic idea here is two-fold. One problem with investing is that a chosen investment may underperform, so that the investment return is lower than it might be. The other problem is that an investment may fail completely. Not only will the return be lower, but the capital invested in it might be lost. This is the basic idea behind the old advice to not put all our eggs into one basket. We spread the risk around.

However, like all things diversification can be overdone. If we buy shares in too many stocks, our transaction cost will rise for little extra return. Also, if we buy shares in too many stocks, some are going to perform worse than others. The more stocks we invest in the harder it is to focus only on the best performing ones. This is why the great investor Peter Lynch calls overly wide diversification diworsification.

So, too little diversification will not manage risk very well, but too much diversification will decrease risk minutely, but significantly harm the potential investment return. A balance needs to be struck.

Colin Nicholson's books: Building Wealth in the Stock Market and The Psychology of Investing may be purchased from Colin's website www.bwts.com.au and good bookstores). Contact Colin at colin@bwts.com.au or through his web site where you may join the list to receive his free email newsletter.