4: Designing Your Portfolio: The Role of Asset Allocation, Diversification, and Rebalancing

Although you might not be an experienced investor, you may already be aware of some important investing principles from your real-life experiences. For example, have you ever noticed that street vendors sometimes carry seemingly unrelated products such as sunglasses and umbrellas? Why? A customer is unlikely to buy both at the same time, but that’s exactly the point. These vendors are aware that on sunny days, sunglasses are likely to be in demand but on rainy days, people want umbrellas. By selling both products, vendors can diversify their product line and reduce the chance of low sales on any given day. Another example is the wide menu choice in a diner. If these examples make sense, you’re well on your way to understanding the fundamental investing principles of asset allocation and diversification. In fact, asset allocation is the easiest way to diversify a portfolio.