Diversification is the name investing theory gives to the principle "don't put all your eggs in one basket". Let's expand the analogy a step further.
Buy More than One Egg: When buying investment "eggs" it is a good idea to buy more than one - if one breaks or goes bad there are others to eat so you do not go hungry. Similarly an investment in one company is risky since management may mess up. Buying more than one company's stock is a wise thing. That is the first way in which diversification reduces risk while allowing you to obtain the benefits of higher return investments.
If you buy several mutual funds and they happen to hold the same companies within them, then all you have done is buy more of the same companies and you have achieved diworsification. Buying more of one company increases your exposure to that company's fortunes and makes your overall holdings riskier and therefore worse. When you buy any collective investment like funds, you need to look inside at its holdings to verify that it is substantially different from what you already have.
Buy More than Just Eggs: Ever notice that when good or bad economic news comes out, often the shares of a whole sector such as banks or oil companies go up or down together, or perhaps even the whole stock market? That phenomenon is called correlation. Investments that change value or move up and down independent of each other are said to be un-correlated and if they move in opposite directions (if one goes up the other goes down, but only temporarily since all investments should move up eventually - each has its day to shine), they are termed negatively correlated. Combining un- or negatively-correlated investments, such as real estate and stocks, smooths variations and reduces risk. A grouping of investments that behaves similarly is known as an asset class. Thus the second way to diversify is combining in a portfolio these non-correlated investments, non-eggs in our analogy. In investing, as in food, eating only one thing, though it may be good for you, is likely to give indigestion or worse. A balanced diet is advisable and a combination of ingredients, or asset classes, can make a tastier dish than a single ingredient. The combination is better than the sum of the individual securities.
Diversifying amongst multiple asset classes for a given level of return will minimize the risk. It is important to note that the correlations among asset classes can vary tremendously from year to year despite the long term tendencies. However, despite the fact that the investing world is not fully predictable or stable, it is possible to build a darn good diversified portfolio that will give excellent stability and higher return.
In the next post, I'll describe the major asset classes and how to combine them in a portfolio.
Investor Solutions - Chapter 5 Travels on the Efficient Frontier
Richard Ferri's book - All About Asset Allocation
InvestorHome article on Asset Allocation