One of the most important knowledge about investment is understanding risk. While it is important to think of potential returns one may make, it is equally important to understand risks and manage the risks properly to avoid losing money.

Most people were told to diversify their investments in order to mitigate the risks. In general, you invest in a few products with different level of risks. By doing so, you will be investing in several types of investments that expose you to high, medium or low risks. It is common to find people who are invested in 5 or 10 or more types of investments.

Let me use an example to illustrate. Let's assume there are only 4 types of investments available. They are listed in the order from the lowest to highest risk.

1. Fixed deposit(FD) / Certificate of Deposit (CD)

2.  Property

3. Unit trust / mutual fund

4. Stock

What most people tell you is that you should spread out your investments into the above 4 categories in order to mitigate the risk. Now, let us assign a risk index to each category. Fixed deposit (1), Property (2), Unit Trust (3), Stock (4). For simplicity sake, assume you invest equal amount in each category. Then, your average risk is (1 + 2 + 3 + 4 ) / 4, which equals to 2.5. This looks like a good strategy, right? Well, there is nothing wrong with this approach. However, let’s consider the following example.

Instead of investing in all four categories, you can also invest only in Fixed Deposit (1) and Stock (4) only. This also gives you the average risk index of (1+4) / 2 = 2.5. By doing so, you achieve the same level of risk management, but only expose yourself to 2 types of investment products. What this means is you save a lot of your time by investing in less products. This usually implies you tend to do better overall because you can afford to spend more time researching the investment products.

I’m not trying to suggest that you should only diversify your investments into 2 products. Rather, the point is, you should not over diversify by investing in too many products.

So, the next time someone talks about risk and diversification, think of the above 2 examples. Which option do you prefer to take?

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