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The worst of times can bring out the worst in people and this is no less applicable in the investment environment, where previously rosy looking investments can suddenly lose their blush.

Recently, there have been several spectacular local and international investment failures that have attracted much media attention. Interest is often (and somewhat justifiably) focussed on the perpetrators of the collapsed schemes, their largesse and society's retribution. However, less seems to be made of the seemingly nameless, faceless crowds of prejudiced investors.

It is perturbing to hear of people losing their life savings to some collapsed investment scheme, not only because it would be preferable if such schemes (and the people who run them) didn't exist in the first place, but more because it is indicative of a fundamental error on the part of the affected investors.

Darron West of Foord Asset Management explains that to ignore the necessity of diversification within an investment portfolio is a cardinal sin of investing. "To lose all of one's wealth to a single investment is to admit that one's portfolio was not a portfolio at all (devoid as it was of diversification).

"Diversification is critically important in risk reduction. It should be used it as often as possible, but not as much as possible. Too much diversification reduces returns. The more conviction you have the less diversification you need."

Diversification: vital for risk reduction

Firstly, what is risk, and why is diversification critically important in its reduction? "In investing, we prefer to define risk as the permanent loss of capital," explains West. (Click here to learn more about what really constitutes risk)

"Typically, this arises when one suffers at the hands of a fraudulent scheme perpetrator, or if one indulges in the seemingly pervasive investor habit of buying high and selling low. Once wealth is lost in this manner, it cannot be recovered. What is more, the remaining base from which one has to earn returns is diminished, which of itself can only diminish future return expectations.

"Diversification in its broader sense is critical because it prevents, or at least mitigates, such risk. It involves investing in assets with returns that have no or negative correlation with each other. By the same token, when choosing fund managers one should also seek those who produce returns that are largely uncorrelated with the other fund managers or with the market itself.

"Diversification also reduces the risk of being wrong which is ever present in investing — to err, after all, is human; other assets should more than make up for the negative consequences of a single bad decision. However, if those other assets are absent, then there is no compensating effect."

Diversify often, but not too much

Secondly, diversification should be used as often as possible.

"This is the antithesis of putting all of your eggs in one basket. It is highly unlikely, unless the fiction of perfect foresight becomes ubiquitous, that any single investment will deliver precisely the return that is expected of it (some may argue that cash fits the bill, but the 'cash-cannot-be-your-long-term-investment-strategy' horse was flogged to death long ago — click here to learn about the fact that your money is not as safe in the money market as you might think).

There is always some circumstance or discontinuity that will upset the proverbial apple cart. Using diversification haphazardly simply leaves the investor open to the risk of capital loss if and when an investment belies expectations," says West.

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