Overweight stocks can make for worthy additions to a portfolio, but investors should consider the context of their rating. Here’s everything about overweight stock you need to know, and how to best approach them.
Like people, stocks can be overweight too. But while humans being overweight is best avoided for the health implications that can arise, an overweight stock is seen as desirable, and something to potentially want more of.
In this article, we will delve into what overweight stocks are, how they can help (or hurt) your portfolio, and what you should do when coming across them.
What does “overweight stock” in a portfolio mean?
Before we dive in, it’s important to note that the term “overweight stock” can mean two things – an analyst rating, and a portfolio allocation.
In a portfolio allocation, an overweight stock simply means that there is too much of that stock in the portfolio, which can lead to weaknesses or disadvantages. For instance, let’s say your portfolio is 50% AAPL, 20% GOOG, with the remaining spread across a few ETFs.
You might say that AAPL and GOOG are two overweight stocks in your portfolio – a situation that might be worth addressing.
However, analysts use the term “overweight stock” in a different – some might say, roundabout – way, which needs some explaining.
What do analysts mean by “overweight stock”?
When an analyst rates a stock as “overweight”, this is an indication that they are convinced the stock will do well in the coming forecast period (usually six months to a year, depending on the analyst).
The reason behind their conviction can range from better-than-expected guidance from the company, increased demand, a favourable legal ruling, a change in macroeconomic conditions, positive news announcements, and more.
Based on the factors above, analysts believe the stock will outperform its sector or market benchmark. Hence, they recommend that the stock take up a larger portfolio position – relative to the market average.
Commonly used benchmarks are major market indices. such as the S&P 500, the Russell 2000, etc.
By increasing an “overweight” stock such that its allocation is larger in your portfolio compared to the benchmark’s, you increase your chances of outperforming the market.
Note that “outperform” can mean both a larger gain in value or simply, a lesser loss in value, compared to the benchmark.
Example: Overweight stock in action
Let’s illustrate with an example, using the S&P 500 as our market benchmark, and AAPL as our stock.
Currently, AAPL takes up 7.6% of the S&P 500. Assuming analysts give AAPL an “overweight” rating for the next 12 months, they believe that the stock should occupy more than 7.6% of a portfolio that mirrors the S&P 500 – thus “overweighting” the stock, relative to the market average.
This is so that should AAPL perform according to the analyst’s expectations, an investor with a larger position in the stock stands to reap greater returns.
So, does “overweight stock” mean buy?
Generally speaking, an overweight rating can be taken as a positive indicator and a signal to buy a stock.
But for a more precise definition, it depends on the actual rating system used by the analyst.
There are commonly two types of rating systems, a three-tier and a five-tier system.
A three-tier system is the simpler of the two, and it might look something like this:
- Buy (or overweight)
- Sell (or underweight)
In a three-tier rating system, Buy and Overweight may be used interchangeably, and generally mean the same thing.
Meanwhile, a five-tier system offers a greater degree of nuance, as follows:
In this case, an Overweight rating doesn’t have as high a conviction as an outright Buy rating. Instead, it suggests holding more of a stock than market benchmarks may suggest.
Thus, if your portfolio is already overweight on the stock, you may not want to add to your position, until the stock hits a Buy.
Pros of overweight stocks
Analysts regularly publish stock ratings online, making overweight stocks easy to find. You can simply search for them online, or look up your favourite brokerage or market news website to check the latest ratings of the stocks you’re interested in.
Potential for greater returns
Overweight ratings on stocks are just another way of saying that analysts expect the stock to perform better (or decline less) than the market average. Hence, overweight stocks have the potential to help a portfolio achieve better returns overall.
Find market trends
Overweight stocks can also act as a precursor of coming market trends. Take for example, the Invesco QQQ ETF, which tracks the top 100 tech companies listed on the U.S. stock exchanges. An influx of several leading tech stocks earning “overweight” ratings can potentially signal a coming bull run in tech stocks.
Cons of overweight stocks
Based on opinions
Stock ratings ultimately amount to an opinion on the future performance of a stock. An option based on analyses and metrics and data, sure, but an opinion nonetheless.
This means that investors shouldn’t take overweight stocks as surefire winners. Rather, bear in mind that stock ratings simply highlight potential opportunities.
It’s worth noting there is no standardised definition for whether a stock should be rated overweight or not. Different analysts may interpret data differently, and come up with varying ratings for the same stock.
This is to be expected – after all, no singular analyst or group of analysts can make 100% right calls 100% of the time, given the nature of the stock market. Therefore, it’s wiser to look for consensus among a range of analysts, rather than simply sticking with one or two.
There is a limit to which investors should take overweight stocks, beyond which risks will increase. Understand that being overweight on some stocks also means leaving less space in your portfolio for different stocks – ones that may act as a counterbalance.
Hence, going too far with overweight stocks can reduce diversification in your portfolio. This will increase the level of risk in your portfolio. When overweighting your portfolio, be sure to consider the downside – if the market moves against you, will you be able to take the financial pain?
Conclusion: Take overweight stocks in balance
The key takeaway is that there is no surefire way to predict which way a stock will go. The market is dynamic, and while analysts try their best to account for all factors, ratings can – and do – change in response to unexpected developments.
What this means is that overweight stocks should be taken in the investor’s own unique context.
Remember that when choosing a stock, you need to consider its impact on your portfolio, and how well the stock fulfils your needs and preferences. To start trading stocks via CFDs, you can first open a live account with Vantage. This will give you access to trading stock CFDs, at $0 commissions for US stocks!