It is achieved by combining a series of investments together, such as those in the asset allocation table, and ensuring that the selected asset classes do not move (price movements) in the same direction. For example, if you selected to buy two different industry stocks (stocks that are in separate business areas) in a portfolio - a Coles Myer and a National Australia Bank Share - you would be diversifying your investment because Coles Myer is driven by the Retail and Food markets and the National Australia Bank is driven by Banking and Finance. A large or poor change in one of these two industries would most likely have no effect on the price of the other - but it would have an effect on the overall portfolio as it is only limited to two stocks and it is possible that only one-half of your portfolio is performing.

Now imagine that this process is repeated over and over again, effectively gaining a portfolio with a large number of totally diversified or unrelated industry stocks. This would mean that even if one industry area decreased in value, your portfolio would still be performing for you because you have diversified your selected range of investments. Increases in negative volatility in one industry sector will not change the overall performance of your portfolio because not all of your asset classes or industry stocks are moving up or down in value at the same time or the same rate. It effectively removes the potential upside and downside to investments and creates a more consistent - if not safer - overall performance for your money

The amount of stocks that need to be purchased in order to reduce the level of unsystematic risk can vary, but portfolio theory (underlying theory behind the relationships between risk and return) estimates that about 10-12 diversified stocks will give a high level of diversification. Remember - this means that 10-12 totally unrelated industry stocks in different assets classes will give you the best overall return.

Remember the age old adage“Never put all your eggs in one basket!”

Systematic risk is the risk that cannot be reduced or predicted in any manner and it is almost impossible to predict or protect yourself against this type of risk. Examples of this type of risk include interest rate increases or government legislation changes. The smartest way to account for this risk, is to simply acknowledge that this type of risk will occur and plan for your investment to be affected by it.

Unsystematic risk is risk that is specific to an assets features and can usually be eliminated through a process called diversification (refer below). Examples of this type of risk include employee strikes or management decision changes.

While these are the macro scale levels of risk, there are also some more important micro (small scale)types of risks that are important when talking about the valuation of a stock or bond. These include:

Business Risk - The uncertainty of income caused by the nature of a companies business measured by a ratio of operating earnings (income flows of the firm). This means that the less certain you are about the income flows of a firm, the less certain the income will flow back to you as an investor. The sources of business risk mainly arises from a companies products/services, ownership support, industry environment, market position, management quality etc. An example of business risk could include  a rubbish company that typically would experience stable income and growth over time and would have a low business risk compared to a steel company whereby sales and earnings fluctuate according to need for steel products and typically would have a higher business risk.

Liquidity Risk - The uncertainty introduced by the secondary market for a company to meet its future short term financial obligations. When an investor purchases a security, they expect that at some future period they will be able to sell this security at a profit and redeem this value as cash for consumption - this is the liquidity of an investment, its ability to be redeemable for cash at a future date. Generally, as we move up the asset allocation table - the liquidity risk of an investment increases.

Financial Risk - Financial risk is the risk borne by equity holders (refer Shares section) due to a firms use of debt. If the company raises capital by borrowing money, it must pay back this money at some future date plus the financing charges (interest etc charged for borrowing the money). This increases the degree of uncertainty about the company because it must have enough income to pay back this amount at some time in the future.

Exchange Rate Risk - The uncertainty of returns for investors that acquire foreign investments and wish to convert them back to their home currency. This is particularly important for investors that have a large amount of over-seas investment and wish to sell and convert their profit to their home currency. If exchange rate risk is high - even though a substantial profit may have been made overseas, the value of the home currency may be less than the overseas currency and may erode a significant amount of the investments earnings. That is, the more volatile an exchange rate between the home and investment currency, the greater the risk of differing currency value eroding the investments value.

Country Risk - This is also termed political risk, because it is the risk of investing funds in another country whereby a major change in the political or economic environment could occur. This could devalue your investment and reduce its overall return. This type of risk is usually restricted to emerging or developing countries that do not have stable economic or political arenas.

Market Risk - The price fluctuations or volatility increases and decreases in the day-to-day market. This type of risk mainly applies to both stocks and options and tends to perform well in a bull (increasing) market and poorly in a bear (decreasing) market. Generally, the more volatility within the market, the more probability there is that your investment will increase or decrease.

The lowest level investments are comprised of smallest amount of risk and volatility and therefore represent capital stable income-producing investments. While they don’t offer a large return - the return on this asset class is practically guaranteed. This area is typically for the more conservative investor and would represent the bulk of their asset allocation.

The medium level investments have an intermediate level of risk and while they are more likely to provide capital appreciation (rise in value) than decline, there is greater chance of loss than the lower asset class. A mixture of both these assets and low level stocks is for an investor with a medium risk tolerance.

The highest level of asset allocation is for investors that have a strong understand of the stock market or have a high risk tolerance. Typically, these investors seek to gain large returns in exchange for large amounts of risk. A mixture of these assets, with high-medium end assets requires an investor to have the highest level of risk tolerance.

Getting the mixture of these assets classes correct is the key for every investor in respect of their risk tolerance, intrinsic and time values and investment objectives. The stronger understanding investors have of their asset allocation - the better picture they can have of their investment returns.

For example, compare the loss of an investment of $10,000 to someone that has $1,000,000 in cash against someone that has only $50,000. Clearly, the person with more money is less affected by the loss of the investment than the person with less money. This is because the person with the higher capital base (the assets they own) is able to absorb more risk than someone with a smaller capital base and therefore have the ability to take a higher level of risk on this investment.

The time value of risk is that amount of time that you are able to keep your money invested. For instance, if you require your money in 6 months in order to fund a new business - investing in high risk securities may not be the most advisable course of action ? equally, if you don’t need your money for another 10 years it might be worth investing in. The riskier an investment is, the higher the volatility or price movements of the investment are. In short spans of time, these high price movements may mean losing a significant amount of your initial outlay - conversely across a long period of time these price movements may become less variable and therefore a greater investment return can be made.

The risk-reward concept states that while your investment decision can reap fantastic profits, you must be willing to accept a loss if it doesn’t. This is the fundamental reasoning behind ensuring you know you own personal risk tolerance - the degree to which you will accept a certain level of risk. When choosing investments to spend your money on, the risk tolerance is critical to guaranteeing that you don’t enter investments that are beyond your range of financial comfort.

Realizing that some risk must be adopted in order to receive a return is underlying to the investment process, but equally managing this risk to your tolerance range is more important. Not being able to sleep at night worrying about your investments is clearly an adoption of too much risk - equally knowing that your money could be working harder and faster for you to get a higher return, is an adoption of too little. The appropriate balance between these two extremities is the ultimate goal you wish to achieve to establish how much risk is right for you.

Risk can be assessed both objectively and subjectively and it is the difference between the two that creates the risk-reward concept. Anytime that you decide to adopt an investment, there is a chance that you may not get the money back - it is this principle that drives the risk-reward process. The higher the level of risk that you choose to adopt in your decision making - the greater the potential there is for a return. Equally the higher the level of risk, the higher the chance there is for an equated loss.