Once upon a time, over a cup of tea on the front porch, Andy’s grandmother gave him some important investment advice: “My boy, remember that you should never put all your eggs in one basket.” “This,” she said, “is the key to investment success.”

She explained that she had diversified her investments. She had split her investments equally between two banks. All the money was either on call or in a fixed deposit, depending on the banks’ rates.

This spreading of her risk made perfect sense to Andy. It was only a while later that he realized her error – she had not spread her risk at all.

Putting your eggs in two baskets is not good enough. You need to put your eggs in a basket and a padded box. The basket may carry more, but the box is safer. If you fall carrying two baskets, the dangers are equally great. With a padded box, you will be a lot safer, although you will not be able to carry that many eggs. This is a more appropriate way of spreading risk.

Andy’s grandmother should have diversified her investments by putting some money into shares, property, or fixed-interest investments (bonds) as well. True diversification means that she should spread her money among investments with different characteristics that will react differently.

A properly diversified portfolio must have an underperforming component to it.

We could use an example of Fred’s ice-cream shop on the beachfront to illustrate what effective diversification really is. On a hot day, visitors form long queues to buy an ice cream. To earn extra income and reduce his risk, Fred decides to sell cold drinks as well.

By doing this, he increases his income slightly. But this is not effective diversification because this additional product line will not solve his problem on a cold day. So, instead of selling cold drinks, he should sell hot chocolate as well – this would be effective diversification and reduce his risk.

If only life were this simple! Unfortunately, Fred only has a finite amount of money. Because he does not have limitless cash, he will not be able to ensure that he has sufficient stocks of ice cream and hot chocolate for the extremes of weather conditions. How can he be one step ahead of the game and keep the right balance of stock? Even the best stock management system is not going to cater for “scorchers” and “freezers.”

By blending the two, however, he is getting the best of both worlds, although there will be times when he misses out on the jackpot.

If this strategy is so self-evident, why do we not apply this philosophy to our wealth-creation strategy? All you need to do is replace hot chocolate and ice cream with cash and equities (shares). There are times when we should have equities on the shelf and others when we need cash.

It is exceptionally difficult to determine when those times will be, but it makes a great deal of sense to have a blend between the two. You will miss the peaks, but you will also miss the troughs. This balance will reduce your risk and effectively diversify your portfolio for better long-term returns.

This way, you give up the chance of making a killing under extreme conditions to reduce the possibility of being killed.