For instance, the stocks of domestic companies are believed to be more stable compared to international ones, but adding a pinch of international shares to a portfolio does work some magic (as per modern portfolio theory described by H. Markowitz):
Historical index data for 1973–2013 Source: https://youtu.be/0RTV8VdavqU
In the above, by investing 30% in major international equity markets (Europe, Australia, and the Middle East), we don’t increase the return of the portfolio much but we do reduce the risk. Then, by diversifying our portfolio even more and buying 10% of a third type of investment vehicle, we add an even riskier asset class—small overseas companies. However, after the last manipulation, both our returns and risk levels change significantly, turning odds in benefits.
How does rebalancing work?
Rebalancing is a way to readjust the weightings of a portfolio through periodic reviews undertaken to maintain the original risk–return preference. In other words, imagine that you have invested in corporate bonds and local and international stocks in proportions equal to 50%, 30%, and 20%, respectively, such that today your $100,000 capital is distributed among various securities as follows:
$100,000 X 50% = $50,000 in corporate bonds,
$100,000 X 30% = $30,000 in US companies,
$100,000 X 20% = $20,000 in international companies.
This is the perfect picture:
