This is the fourth article in Shaun Latter's 15 part series on the fundamentals of investing. Also read the other articles in this series:

1. You are your biggest risk

    

2. Saving yourself poor

    

3. How risky are stocks?

Diversification; a term that most investors are familiar with, yet few understand the role it should play in their investment strategy. This, in turn, leads to most being diversified for the sake of being diversified and end up picking and choosing a variety of fund managers, asset classes and even companies in a desperate attempt to avoid "having all their eggs in one basket" (a.k.a. concentration risk). Although this is, broadly, a very prudent approach to adopt it gives little regard for what the investor?s required objectives are and often results in returns being unintentionally diluted.

So what should diversification be doing for your investments?

In essence, diversification is not there to drive better returns but rather more consistent returns. Therefore, diversification?s main objective should be to manage volatility.

With equities and cash on opposite ends of the risk (and return) spectrum, there are two further asset classes that offer unique attributes of their own. These two asset classes, namely bonds and property, sit snugly between cash and equities, with bonds partnering closer to cash and property closer to equities.

The general rule of thumb regarding the risk vs. return trade-off is that the higher the risk the higher the potential return and vice versa.

If we had to translate this to a ranking of these asset classes from lowest to highest risk (volatility), the order would be cash, bonds, property and equities. Cash and bonds selected as risk assets to manage volatility and property and equities as growth assets to drive returns.

So, diversification should mean different things for different investors. For a pure equity investor, this may mean holding stocks across different sectors (resources, financials, industrials, etc.) and perhaps even different companies within a sector.

So not only should diversification through active asset allocation allow for solid mitigation of risk, it will also allow for specific construction relating to your individual needs. In other words, although inflation-beating returns are critical for investment success, each investor may need to beat inflation by different margins and therefore have a different spread of assets to achieve this return.

At the end of it all, one should aim for their own eat well/sleep well investment strategy. That means having a spread of assets that will ensure that you "eat well" down the line whilst still being able to put your head on a pillow at night and "sleep well" (even in volatile times).

Join me next week as we explore these asset classes in more detail and discover what role each one plays in your investment strategy.

www.shaunlatter.com