Tis the part of a wise man to keep himself today for tomorrow, and not to venture all his eggs in one basket. - Don Quixote de la Mancha (Miguel de Cervantes, 1605)

For passive investors, diversification is absolutely crucial. The more you want to sit back and let your investments grow without worry, the more important it is.

If your time frame is particularly long, then you can afford to put yourself into growth assets like shares and property, without worrying about other asset classes. For shorter time frames it becomes important to limit market risk by spreading across a wider variety of investments.

Unfortunately, very few people really watch their stocks closely enough to enjoy the benefits of "focus" investing, as described in the shares FAQ. A stock that is ignored is dangerous, while the market often has ups and downs which long term investors can afford to ignore, companies themselves are subject to fluctuating fortunes. If you buy some supposed "blue chip" stock on the recommendation of a family member, TV show or guru for hire, but take no further interest in it since it is "long term", then you stand to lose a substantial proportion of your capital.

Even major fund managers with supposedly the best information were left holding huge parcels of OneTel and HIH recently, as was the case in the 1980s with Bondcorp, Quintex and Ariadne. Notwithstanding the theory that perhaps a competent focus investor would not have put money into these types of stock anyway, there are thousands of ordinary civilian investors right now who are really hurting because they had sunk huge amounts of their savings into stocks that got suspended and then became worthless.

For most people, people who have actual jobs and aren't involved in the investment industry, it makes sense to diversify your holdings. The average managed fund, even if they were holding their full quota of OneTel and HIH would have registered a tiny blip of only a percentage point or two because these were only minor holdings. If you want to outperform the market by investing in a few of the companies about which you are particularly bullish then you absolutely must keep right on top of events at this company. Otherwise you really shouldn't be in direct stocks and ought to diversify. The cheapest way to diversify is with index funds that charge no substantial fees. Even if you had an el-cheapo discount broker and you could buy at only a few dollars a trade, to buy 100 stocks as you would do with a moderately small index would still cost hundreds of dollars in brokerage. The average entry fee into most funds is far cheaper than brokerage on many individual stocks, therefore pooled funds do offer an economy of scale you won't find if you do it yourself.

That is just for long term investors. For people who may want to cash in their investments in under a decade it makes a lot of sense to invest across all the different asset classes as well. The stock market is notoriously difficult to time and notoriously volatile, there is no guarantee that you will have a positive return in any particular year, in fact there is a very good chance of having a really terrible return over short periods. Stock strategies depend on taking a long term view to wipe out the vagaries of market movements. The only option to a short term investor (as opposed to short term speculator) is to invest money into cash, bonds, property and stocks, both within and without Australia. I will expand on this in the first couple of articles in the managed funds section of this FAQ.