Stories abound about a great-uncle who bought shares in a single investment, forgot about it and died before he could find out he was a multimillionaire as a result of his single punt.

When the single punt makes money – as, say, a punt on Microsoft when it first launched has now done wonders for its initial investors – it appears to be a smart move. When investors first bought their shares, however, they took a huge risk.

The problem with identifying the next big investment is that is there is no crystal ball to predict the future. History is full of examples of what people mistakenly believed would be the next big thing.

The reason you invest is to generate returns, and there is always an element of risk, but you can mitigate your risk by diversifying your investments.

Three ways to diversify your investments

1. Spread your risk

If you invested all your money in the shares of a single company, you could lose almost all your money. Similarly, if you invested in a single bond and the issuer declared bankruptcy, you could be left with nearly nothing.

Diversification is about avoiding such a situation. So, instead of investing in a single share or bond, you invest in a portfolio of shares or a pooled investment like a unit trust fund, which invests in more than one bond.

Then, if the shares of some of the companies or some bonds drop to rock bottom, other shares or bonds in your portfolio may be performing well.

That, in simple terms, is called diversification. It doesn’t guarantee profits or protect against loss, but is likely to help protect your portfolio except in extreme cases such as the recent great financial crisis when almost all shares and bonds suffered losses.

2. Diversify across asset classes

Among the four main types of assets in which you can invest, shares are considered the riskiest and cash-like investments the least risky.

Generally, the higher the risk, the greater the reward – so while shares are considered the highest risk, they also hold the potential for the greatest returns. Bonds are less volatile but their returns are more modest, and cash-like investments are generally considered to carry the least risk but with the lowest returns.

By diversifying across asset classes – shares, bonds, property and cash – you can temper your losses because historically these assets tend to move up and down as market conditions change. Conditions that cause one asset class to do well often lead to another having average or poor returns.

Splitting your assets across classes, referred to as asset allocation, will balance your portfolio. Investors typically choose a percentage they want to invest in each asset class based on their risk tolerance, their time horizon to achieve a specific financial goal (such as years to retirement), and other factors.

For example, you could choose to invest 80% in shares, 15% in bonds and 5% in cash if you want reasonable returns and are comfortable with taking on some risk. But if you have a short time horizon and cannot stomach significant fluctuations in returns, you would be better off with a more conservative asset allocation with less invested in shares and more in bonds and cash.

Time affects performance in that the range of returns is less pronounced over longer periods. In other words, the longer you invest, the lower the likelihood of significant losses – but on the flipside, the returns will also be more muted.

3. Diversify within asset classes

After spreading your investment funds between shares, bonds, cash and property, you need to diversify again within each of these categories. Therefore you should choose a range of shares, a range of bonds with differing maturity dates, and different cash and property investments for your portfolio.

Diversification in shares is most effective when you invest across countries, industries and companies of differing sizes to help even out the ups and downs. For example, you can buy shares in large, medium-sized or mid-cap companies, diversify between domestic and offshore companies, and diversify by industry and sector.

Rebalancing

An important component of diversification is rebalancing your portfolio, which becomes necessary when market movements upset your allocations to asset classes or market sectors.

For example, if some of the shares you own perform exceptionally well, it is possible that shares, as a class, will make up a greater proportion of your portfolio relative to the bonds, property and cash than you originally intended.

If, say, your strategy was to hold 80% in shares, 15% in bonds and 5% in cash, after a market run the value of your shares might increase to such an extent that they represent 95% of your portfolio. That would increase your risk because shares are the riskiest of the asset classes. Should the share market then fall, it could affect whether you’ll meet your financial goals.

Rebalancing will require you to sell some shares and buy more bonds and cash until each asset class represents the right proportion of your portfolio.

Pooled investments

Unless you are wealthy, investing in the shares of many different companies to achieve diversification may be beyond your means. Perhaps you simply do not have the time or inclination to research the huge variety of investment options available, make the asset allocation decisions, decide on individual stocks and bonds, and so on.

You can diversify your investments by investing in collective investment schemes. These include shares and exchange-traded funds, which pool the money of many investors into a single fund. In these funds, a professional asset manager takes responsibility for diversifying your investments.

The advantages of pooled investments are that they are managed by professionals whose sole task is to manage funds; they provide instant diversification; they are cheaper than investing in the same basket of assets compared with purchasing each investment individually; and they allow you to get your money back promptly at relevant, market-related prices should you choose to disinvest.

There is a range of pooled funds available with different investment objectives and asset allocations, so you can choose funds aligned to your needs.

Is there such a thing as over-diversification?

There’s no “correct” number of funds you should own, but if you buy more than one, there is a chance of some overlap in the underlying investments. You could end up owning the same shares or other assets multiple times in different funds or investments.

Before buying a new share or investing into another pooled fund, you need to know what its role is in your portfolio and how it will improve the performance of your portfolio. Simply adding a new investment to your portfolio because it “looks good” from the marketing material is not a good enough reason.

Owning a hodgepodge of investments is difficult to manage. It is better to settle for a simpler portfolio that balances risk and return more efficiently.

In summary

If you want to make the most of your investments, owning a well-diversified portfolio with a high weighting in domestic and global blue-chip companies will consistently deliver the highest returns over the long term.

However, it is important that your diversification strategy is aligned with your personal financial goals and tolerance for risk. If you’re uncertain about how to diversify, a financial adviser will be able to help you.

•This guide was written by the Money editorial team at Tiso Blackstar, sponsored by Discovery Invest.

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