How does it work?

If you decide to invest in shares (equities) you may like the oil industry, chose, e.g., BP and put all your money into BP. That's sort of logical.

But businesses are risky affairs and you have put yourself at the mercy of all the accidents that might befall BP. You can still maintain your conviction about oil by splitting your investment between BP and, e.g., Shell. So you've halved your exposure to BP's accidents and taken on some exposure to Shell's accidents: you've 'spread your risk', or 'diversified'.

Except that you haven't done it very well. Both BP and Shell depend on the oil price. You've diversified the risk of, e.g., 'management mistakes' or 'plant accidents' but you've not diversified exposure to a fall in the oil price. You would do better to make your second investment in, say, GlaxoSmithKline.

But why limit yourself to two companies? Perhaps you should reduce your investment in BP and GSK and introduce another industry - insurance, say?

The lesson is.....

You need to build a collection of investments as different from each other as possible, to spread your risk. To do otherwise is to pretend that you have more knowledge than the market - in the BP/Shell example to believe that your assessment of the future of the oil price is better than the market's. And it isn't.

This process is called ‘diversification’. It is sometimes described as ‘the only free lunch in investing’. There's much more to be said if you want to get clever. Luckily, you can safely leave this to Hard Money. Remember that in Easy Money we recommended you bought a fund to achieve diversification.

The collection of diverse investments you end up with is called your 'investment portfolio'.

A final thought

Don't be ashamed to use the 'eggs in one basket' definition to help you think quite widely about this. For example:-

• Pay attention to counterparty risk - the danger that a party in the legal chain that connects you to your present and future wealth will fail.

• Do you invest in the company you also work for? That means your job and your savings have a common risk - corporate collapse. We don’t say ‘don’t do it’. We say ‘be aware of the risk’.

• Do you only invest in ‘businesses you know’?

• Do you put all your cash savings with the same bank?

• Do your investments all depend on the stability of the same country?

There are no rules here - just an encouragement for you to think widely and use the common sense of yourself and your friends.