Diversification is the process of dividing your wealth between different investments to avoid being too reliant on any single one doing well. In plain English, it’s all about making sure you don’t keep all your eggs in one basket.
The purpose of diversification is to reduce your risk (as measured by the volatility of your portfolio), while maintaining a decent level of return. For example, if you own just one stock, then your portfolio is entirely dependent on the fortunes of that one company. If you own 15, then even if one or two perform badly, or go bust, then the others in your portfolio should help to compensate for the loss.
While there’s no ideal level of shares to hold, some research suggests that once you get above 20 well-selected shares, the marginal benefits of adding more is small. However, this assumes the shares are themselves well diversified – if you hold just 20 oil companies, for example, you are still heavily exposed to the risks of a single sector.
In addition, the size of each investment is important: if you have 100 shares, but half your portfolio in a single stock, you are not sensibly diversified. A good diversification strategy combines all these principles: you might set yourself a rule of holding 20 stocks, with no more than two in each sector and no more than 10% of your portfolio in a single stock (and no more than 20% in three and so on).
As well as diversification within an asset class, you should diversify between asset classes, because different assets tend to behave in different ways depending on the economic backdrop. For example, bonds will do well during periods of falling or low inflation, while gold tends to benefit during periods of financial instability.
Your exact mix of assets – or asset allocation – will depend on your investment time horizon and risk appetite.