'Further Diversification' sounds complicated but it's actually a simple process. All it means is that all investments in every asset class carry a different level of risk exposure. The asset class that will have the greatest impact upon the volatility of your portfolio will be your equity-based investments. Clear so far?
You can make your equity portfolio more or less risky by including shares from these areas:
UK and Overseas
In theory, investing across a bunch of different markets should reduce your risk while exposing you to more opportunities. The UK market is dominated by a small group of industries like banking, telecoms, oil and pharmaceuticals. So if you limit yourself to investing only in the UK you'll be leaving out the other 90% of the world's investments. You could be missing out on investing in some of the world's biggest companies and the chance to reduce your dependence on the U.K. stock market.
However, chances are you'll know more about UK companies than anywhere else. Which means you'll find it easier to assess their prospects. The UK market also contains lots of companies that operate all over the world giving you a much wider exposure to the world economy.
So it might be an idea for UK investors to get an equity portfolio based mainly on UK listed companies.
Large or Small Cap
The type of company you choose to buy shares in can have a major impact on your portfolio. When thinking about risk, a useful rule of thumb is that the larger and more established a company is, the more stable its share price will be. A portfolio dominated by small start-up companies will usually be more volatile than one dominated by blue-chip shares. The usual way of showing the size of a company is by its Market Capitalisation (Market Cap). Companies are categorised as either large, medium or small cap.
Sectors
For a tip-top portfolio, make sure that your shares come from a wide range of sectors (like financial services, retail, manufacturing, and so on). If you let your portfolio become dominated by just one sector, it'll end up relying on that sector for its performance. Which is way more risky for you.
You don't really need to look further than the dotcoms of the 1990s. Back then, you might have had a look at the stock market and decided it would be a good idea to stuff your equity portfolio chock-full of technology, media and telecoms. Which would be a bit of a balls up as the whopping great falls in those sectors have subsequently shown.
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