When deciding whether to buy a particular asset, we should also pay attention to the assets we already own.

A collection of assets is called a portfolio. By buying and holding assets with different characteristics, we can try to create a portfolio that offers the greatest return for the risk we’re prepared to take.

Holding such a mix is called portfolio diversification, and it has been described as ‘the only free lunch in finance’, since statistical studies have suggested it’s possible to reduce your risk to some extent without overly reducing your return.

Inevitably, diversifying away from the highest returning asset will reduce your return. The ‘free lunch’ isn’t an ‘All You Can Eat’ buffet!

Lower returns are the cost of ‘insuring’ yourself against greater losses.

Why you need to diversify your portfolio

Some investors dismiss diversification, saying you’ll make the most money if you hold only the most lucrative asset.

Obviously, that’s true. The trouble is you can’t be sure what that asset will be in advance, particular over the short-term. Also, the highest returning asset will usually be the most risky one, so the chances of loss are greater, too.

There are also time factors to consider when deciding what assets to hold.

Shares are the best performing asset over the long-term, but not always in the short term. A bear market in shares can savage your returns and your net worth.

For this reason, even investors with a long investment horizon will often hold a portion of their portfolio in less volatile assets. There is no point putting all your savings into shares for a prosperous retirement, only for market gyrations to cause your hair to prematurely fall out!

It’s very difficult to know what your attitude towards stock market volatility is until you’ve experienced it hitting your investments.

I’m comfortable buying in bear markets, but I’ve still felt bad about losing money. Because investors are only human, they will often want to hold less volatile investments with their shares to smooth their returns over shorter periods, even though it costs them money long-term.

The appropriate mix of assets will change over your lifetime, too. One rule of thumb is to invest 100 minus your age in shares, and the rest in bonds. Like this, you’re less exposed to drops in the stock market as you approach retirement.

Key principles in diversifying your portfolio

There are two types of diversification, horizontal and vertical diversification.

• Vertical diversification spreads your money between different types of assets. Cash, government bonds, corporate bonds, property and shares can each be expected to behave slightly differently, and so potentially produce different returns, as circumstances change.

• Horizontal diversification is when you hold different instances of the same asset class. This time you’re trying to reduce localised company or sector-specific risks, particularly with shares. Buying an index tracker is a cheap, efficient way to maximize horizontal diversification.

Creating a portfolio that offers the greatest return at the lowest risk is the Holy Grail of investing. Plenty of advisers will charge you for supposedly doing it, and some people have won Nobel prizes claiming to have done it, but there’s no foolproof rules you can follow.

The very best mix of assets you can hold to maximise return for a given level of risk is called the efficient frontier, after the risk/return curve described by particular combinations. The excellent MoneyChimp website has published a good, if rather long and technical, explanation of the efficient frontier if you’re interested.

I’ve read that article and the maths on the following pages and only understood half of it, so don’t worry if you’re linear regression theory is a little rusty. What’s clear from this and dozens of other books and articles is that there is no certain shortcut to the perfect portfolio.

Splitting a portfolio by large numbers works fine in practice. Tweaking by allocating an extra 1% here or there makes little difference to returns, even if you believe you can accurately predict the result in advance.

Portfolio diversification in practice

For most investors, the simplest approach is to split our portfolio between cash, government bonds and a stock market index tracker, perhaps by following the ‘100 minus age’ rule above to determine the allocation given to shares.

If you want to get funkier, you can might add property (via REITs or a buy-to-let investment) or perhaps even corporate bonds to the mix.

To complicate things further, you might invest some of your portfolio in an ETF or fund that invests in small-cap value or growth shares. If you allocated 10% of your portfolio to such a fund, you’d expect greater returns over time to compensate you for the risk and volatility. (Such an investment would count as part of the total share allocation of your portfolio, NOT an asset class in its own right.)

Those of us who invest directly in individual shares will need to consider whether our picks are too correlated with each other, as well as deciding what vertical diversification is appropriate. For more information, read my article on diversifying a portfolio of high-yield shares.

Final tip: remember a portfolio changes over time

As some assets do well while others do badly or simply hold their value, the inherent diversification of your portfolio will change.

A common example is an investor who puts 25% of their wealth into the stock market, and sees it double over a few years. If nothing changes, they now have 40-50% of their wealth exposed to one asset class, instead of the 25% they were initially comfortable with.

Another example was the dotcom boom, where stock market investors became massively overweight in tech shares due to that sector’s success, only to lose the lot when the shares crashed in 2000-2003. A similar thing happened recently with resource stocks.

The subject of rebalancing your portfolio is an article in itself, but for now remember to guard against your risks becoming unintentionally concentrated, whether due to success or failure.