Stories about superstar investors making a fortune out of a single stock investment continue to do the rounds, but very little consideration is given to the amount of risk that was inherent in that single investment, and how many other investors employed this single stock strategy only to fall flat. Investing all your money into one stock implies that your return is entirely dependent on what happens to that particular stock. Having exposure to different kinds of investments that are unrelated, or as we say in financial terms, uncorrelated, prevents an investor from putting all their eggs into one basket and therefore significantly reducing the probability of losing everything all at once.The first component of the traditional diversification process involves asset allocation, which involves splitting the portfolio across asset classes such as stocks, bonds or real estate (for example). When macroeconomic conditions cause one asset class to perform poorly, the underperformance is more than likely offset by superior performance in another asset class. In the longer term, this results in a smoother return profile and improved capital protection. The second component of spreading portfolio risk is diversifying within asset classes. In the case of equities, this may include selecting between domestic and global stocks, large, mid and small cap stocks, and selecting industries and sectors offering the maximum risk-reward potential. With regard to bonds, diversification would largely occur across different maturity dates as well as on the type of bond – government, corporate, high yield – for example. As integral as diversification is to the portfolio construction process, it is not without certain pitfalls. Constructing a diversified portfolio requires in-depth knowledge of each individual investment as well as the ability to rebalance the portfolio in response to changing market conditions - a daunting task even for investors who possess quality resources and information. Maintaining a diversified portfolio can also be significantly more expensive than a concentrated one and the addition of more asset classes or instruments simply contributes to a rise in expenses. These extra expenses cut into returns and have the added effect of magnifying losses during periods of portfolio underperformance. AFP.