You may have heard the saying ‘don’t put all your eggs in one basket’ but you may not know that it’s attributed to Miguel de Cervantes who wrote Don Quixote in 1605. It’s an oft overused analogy but the advice is still relevant today when it comes to your investments – don’t have all you money in one place as you could lose it all in one go.

This potential for loss may be the reason that some people are wary of investing but there is a process which can help mitigate some of the risk – diversification. This involves spreading your investments across different assets classes, whether these are equities, bonds, cash, or any other. You can also choose different options within each asset class itself. The purpose of this is to help reduce volatility over time. Diversification isn’t intended to maximise your returns but to mitigate risk and smooth out your portfolio’s highs and lows.

Using different asset classes to diversify your investment portfolio is important because not all assets classes are affected in the same way by different events. Those that perform differently to one another can be referred to as uncorrelated asset classes. Typically, bonds and equites are uncorrelated so when one underperforms the other tends to outperform, providing protection against a major loss which could occur if only one asset class was held.

The chart below provides a visual example of the returns of each asset class in any given year.

You can also diversify your investment within an asset class itself to further mitigate risk. For example, if choosing to invest in equities, you could choose both large and small companies, those in different sectors and those in different geographical locations. You could also take a similar approach if investing in bonds, including the option of choosing to invest in corporate or government bonds.

Finally, make sure that you don’t over-diversify. Diversification can only reduce risk up to a point and not eradicate it entirely. Holding too many different investments within your portfolio doesn’t allow any of them to have much of an impact.

It’s also important to remember that no single approach to diversification will suit everyone and you should understand what is suitable for you. We would all like to have guaranteed high returns without any risk but, sadly, this is not a reality. Instead, it’s essential to manage risk and return together which is why diversification – not putting all your eggs in one basket – is so important.