Diversification is one of the key features of a well-constructed investment portfolio.

Diversification means spreading your risk – avoiding concentrating your investments in a narrow area, and maintaining exposure to a wide variety of opportunities. This is known as ‘holding the market’.

It’s important because it reduces the risk of your investments being damaged by events affecting any particular part of the market.

Effective diversification takes several forms.

Firstly, there’s diversification at the asset-class level. An asset class comprises investments that exhibit similar characteristics, behave similarly in the marketplace, and follow the same laws and regulations.

So that means balancing your investments between the stock market – which is traditionally riskier, but can deliver higher returns – and bonds and cash, which are generally safe, if unexciting, investments.

In a steady market, the return on both equities and bonds should rise. But the two asset classes also have a low correlation – meaning that, in general, they act in different ways in response to changes in the market. When equities fall, returns on bonds tend to rise, and vice versa.

This movement is factored into a diversified portfolio through regular rebalancing of the proportion of assets held in each class.

Secondly, you should avoid being over-invested in any one part of the world. If your investments are all tied up in one country, specific events such as elections, uprisings, revolutions and natural disasters could have a major effect on your portfolio.

You could also miss out on opportunities in other parts of the world or in developing markets, which can sometimes offer much higher returns.

Another common mistake is to only invest in what you know well, such as the industry in which you work. This is especially tempting if your employer gives you shares as part of your remuneration package, and these form all or most of your portfolio.

The problems here can be seen only too well with the Enron crash in 2001. The company’s employees were encouraged to invest heavily in Enron shares as part of their retirement plan. The company’s share price famously crashed and the retirement plan dissolved in the face of serious financial problems at the firm, with helpless employees losing virtually all their savings.

Investors caught up in the excitement of the ‘dot com boom’ of the late 1990s faced similar problems when the bubble inevitably burst a few years later.

Of course, market falls affect diversified investments, too – but because each asset class, country or sector forms a smaller part of a balanced portfolio, the pain is less.

It’s like the old saying, what you lose on the swings, you gain on the roundabouts – the positives balance out the negatives, leading to an altogether smoother ride.