There are many types of risk and different diversification strategies to deal with them. Some basic tips:
Invest in a wide range of assets
Some of the important asset categories are stocks, debt-based products (bonds, fixed deposits etc), commodities (including gold) and real estate. Each has different kinds of risks and ideally you should invest a part of your portfolio in each of them. For example fixed deposits in a good bank carry very little risk of default but are highly vulnerable to rising inflation which will eat into the inflation-adjusted return.
While stocks are a good hedge against inflation they are very vulnerable in the short run if the economy weakens like it is happening today in India.
You can invest directly in these asset classes or use mutual funds. Your asset allocation will depend on a number of factors like your age, income, risk appetite etc. For example when you are young it usually makes sense to invest strongly in stocks and gradually switch to debt-based products as you near retirement.
This will help to optimise your investment returns over a period of say 30 to 35 years. This is generally the time period between you getting a job and nearing retirement.
Invest in different types of mutual funds
Mutual funds are the ideal way to diversify your portfolio allowing you to invest in a large number of assets without having to monitor them individually. However to get the maximum benefits of diversification you need to invest in a variety of mutual funds. For example you may wish to purchase a large-cap, mid-cap and small-cap fund, an international mutual fund, a couple of sectoral funds and now you can even buy into gold and real estate mutual funds.
Even if you don't invest in mutual funds you should apply similar principles to your investments. You should purchase stocks of companies of different sizes and which operate in different sectors. Also, it always helps to religiously invest a fixed amount of money every month for number of years just like in a mutual fund's systematic investment plan.
Diversify internationally
This may be the most neglected aspect of diversification. Most investors keep the vast majority of their investments in their home country. This exposes them to any risk specific to that country: for example investments in India may face the risk of a bad monsoon or political uncertainty. Investing in a large number of countries reduces your exposure to such country-specific risks.
Fortunately for Indian investors the opportunities for investing abroad are increasing every year. For example it's possible to purchase international mutual funds or invest directly in international stocks.
Assess your overall financial situation
Your diversification strategy needs to be based on your broad financial position which goes beyond your investments and factors in things like the type of your job.
For example if you work in the IT sector, a large proportion of your human capital is exposed to that sector. You may not want to expose yourself further by buying large quantities of stocks in IT companies. Of course this isn't a hard and fast rule. If you feel you have a special insight into the sector, you may invest there too.
The point is that that you should be aware of the extra risk that you are running.
Similarly, if you own a home, a large part of your total capital is invested in real estate. You should be careful about exposing yourself further to that sector especially in the same city.
Conclusion
There are no magic bullets in investing and diversification is no exception. It won't make you rich overnight but what it will do is to significantly reduce your risk without reducing your return. Every knowledgeable investor needs to understand diversification and apply it to his or her investment strategy.
