The basic idea of diversification is to own many assets, so that if one goes bankrupt your entire wealth isn't destroyed. By spreading your risk to many company's you reduce over all chance of losing everything.
This is basically accepted as a sound investment strategy and for the most part I agree. However it does have one down side in that, If one or two assets boom and make incredible returns, the benefit to your overall portfolio is not that much. That's the risk you take in return for limited loses. Diversification averages the returns both in good times and bad times.
For the average person who has limited knowledge/time/interest in investments this is a excellent strategy and one I highly recommend. In the likes of ETF's or LIC's is great.
For example if you own 20 stocks, and 5% of your portfolio in each. One has a return of 200% for the year. It only affects your total portfolio by 15%.
What I do is, what I call focused or limited diversification (I don't know if I made that up or read it somewhere) I try to limit the amount of stocks I have, and put enough money into the ones I believe will do well, to actually make a difference to me.
If I thought XYZ company was about to boom, and I bought $500 worth of stock, and it returned 100% for the year. I would have $1000 . Whilst this is great and is a fantastic return, the difference that money can make to my life is minimal. However if I put 50% of my portfolio in it the difference to my life is huge.
I try to limited myself to 6-8 stocks and put enough money in to each one that it makes a difference to me. However I do ALLOT of research and reading before making investments and buy with a set period of time for that investment. That is my way of reducing the risk of loss.