In 'Asset Allocation' we saw that equity investment has (historically) provided the highest long term returns of any asset class. But we also saw that it exposes an investor to higher intermediate risk. This risk is investment risk - the uncertainty of future returns; and it can be measured by the variability (or volatility) of a share price.
Diversification is about reducing the volatility of returns. To see how this works, let's begin by looking at two hypothetical shares. Which is the riskier investment, Dinocorp or NewTech?
The movement in NewTechs share price is, on any one day, likely to be far greater than Dinocorps, so the chance of large losses or large gains is much greater. NewTech is far more volatile, and that is the measure of risk in financial markets - the greater the price volatility, the riskier (the more uncertain) the investment.
This definition is not restricted to share prices. Any investment with a known market price can be measured in terms of the volatility of its price.
Highly volatile investments offer the potential for the greatest gains, but also for the greatest losses; whilst low volatility investments offer more certain future returns, but these returns will be lower. A sensible investor will aim to optimise the balance between risk and return.
Let's see how this might be achieved.