When a financial analyst rates a stock as overweight, that’s generally taken as a thumbs up — i.e. the analyst believes an overweight stock will likely outperform other stocks in its industry over the next six to 12 months.
Conversely, if they describe a stock as underweight, they believe that it will perform poorly in the future. Think of these terms as pointers: as if an industry specialist were saying, “You might want to over-weight Stock X in your portfolio” or “maybe you should under-weight Stock Y.”
These ratings are typically the result of factors in the news or pertaining to a specific company’s prospects. But the terms “overweight” and “underweight” also refer to a stock’s weighting in a relevant index or benchmark. Before taking an overweight rating as a green light to buy a stock, it’s important to understand what the terms really mean.
Where Does This Weighting System Come From?
What is an overweight stock? To understand that label, it’s important to know that market indexes assign a weight to the investments they track to be sure that the index accurately reflects the performance of that market sector.
For example, the S&P 500® tracks 500 large-cap U.S. companies. The companies in the index — called the constituents — are weighted by market capitalization. A company’s market cap is calculated by multiplying the current share price by the total number of outstanding shares. Companies in that index are weighted based on the proportion of the overall index their market cap represents.
Other indexes may use a different weighting system. The Dow Jones Industrial Average, for example, tracks 30 blue chip companies and weights them based on stock price. Companies with a higher share price are given more weight than those with lower prices.
Because of these different weighting systems, it’s important to understand that an overweight to a particular stock with regards to one index may not be the same when it comes to another.
So when an analyst rates Stock X as overweight, it’s generally a positive sign. First, they believe Stock X is likely to outperform its benchmark index, or even the market as a whole, depending on market conditions, so investors should consider holding more of the stock.
Bear in mind that an “overweight stock” rating doesn’t necessarily mean that stock is a juggernaut. In a down market, overweight could simply mean the company might not lose as much ground as its peers, or it might grow less slowly than its peers.
When an analyst rates Stock Y as underweight, the analyst believes that Stock Y is likely to underperform its benchmark, and investors should consider holding less of this stock.
Equal Weight Stocks
When an analyst gives an equal weight rating to a stock, that simply means it’s in line with the overall benchmark.
Again, when considering these ratings it’s important to keep in mind the overall context of the market, and what these ratings mean to analysts.
What Does Overweight Mean to an Analyst?
At first glance, the terms overweight and underweight may seem more or less synonymous with “buy” and “sell” — so why don’t analysts use these more straightforward terms?
In fact, the terms overweight and underweight do have a slightly different connotation than simply to buy or sell a security. Rather, the terms suggest a recommendation that a portfolio hold more or less of a particular position than an index or other benchmarks would suggest.
It may mean acquiring more, or selling some, of a particular investment. But it wouldn’t necessarily mean buying something new or selling all of a position. For example, if your portfolio has an allocation to tech stocks, and an analyst recommends overweighting one of those stocks, you may want to buy more of that company. Or you may not need more growth in your tech holdings, so you might look for an overweight stock.
Also, analysts aren’t always comfortable giving specific directions to buy or sell certain securities. The terms overweight and underweight are more like offering guidance: “Here’s what I think of Stock X or Stock Y. I’ll let the investor take it from here.”
In many cases an overweight or underweight recommendation might not be very useful for investors. For example, if an analyst recommends an overweight to a certain commodity but an investor’s portfolio doesn’t hold any commodities, this information may not have much bearing on their situation.
Weightings and Price Targets
So an overweight stock rating can be taken in two ways: First, that the stock will outperform its benchmark index and second that investors may want to take advantage of the increase in price.
When an analyst indicates their belief that a stock will appreciate, they may also state a potential time frame and price target for the stock. So if Stock X, our tech stock, is trading at $75 per share, and the company releases new earnings data that’s positive, an analyst might rate the stock as overweight, with a price target of $100 per share in the coming year.
The Downside of Weighting Stocks
One critique of this rating system is that no analyst, of course, can recommend how many shares investors should buy. It’s simply not possible for analysts to know whether Investor A’s portfolio might benefit from an additional 100 shares of Stock X, while Investor B might want to buy 1,000 shares of Stock X.
As a result, it’s incumbent on individual investor’s themselves to keep an eye on how relevant an overweight stock rating might be for their specific allocation. Buying more of Stock X could, in theory, create an imbalance and reduce a portfolio’s overall diversification. So while an overweight stock might be a good thing, an overweight portfolio usually is not.
What Is an Overweight Portfolio?
Overweight can refer to a portfolio that holds more of a stock or other investments than it theoretically should. For individual investors, this might mean that more of a portfolio is allocated to stock than the investor intended.
For example, say an investor has a portfolio allocation in which 70% of its allocation is held in stock and 30% is held in bonds. If the stock market goes up, the proportion of the portfolio held in stock may grow beyond the 70% mark. At that point, the portfolio may be described as overweight in stocks, and an investor may want to rebalance to bring it in line with their initial allocation plan.
It may come as no surprise that the opposite of an overweight allocation is an underweight allocation. For example, if the stock allocation in the portfolio above fell below 70%, that allocation could be described as underweight in stocks.
The term can also apply in a narrower sense. For example, a stock portfolio could hold too much stock in one company, sector, or geographical region. In each case the holding could be described as overweight.
Professional fund managers may also use overweight to describe portfolios they work with that are off track with their index, including mutual funds, exchange-traded funds, and index funds. From time to time, a fund may get out of line with its benchmark index by holding more or less of an investment that index tracks.
For example, say an index fund is built to track the S&P 500. To track the index, fund managers will usually attempt to hold every stock in the index. Additionally, they will try to match the proportion of each individual company their fund holds to the index as well. So if stock A represents 5% of the original index, the fund will also hold 5% of stock A.
Some funds have a little bit of wiggle room in terms of how far they can stray from the index. Some might be allowed to hold more or less stocks if they think the stocks will outperform or underperform. When they hold more than the index, the managers are taking an overweight position. And when they hold less than the index, the managers are taking an underweight position.
How Can Investors Interpret Overweight Stocks?
Investors looking at stock analysts’ overweight recommendations may want to carefully consider whether those recommendations fit with their financial plan. For example, is the overweight recommendation based on the investor’s same time horizon? If an analyst’s recommendation is based on the next six to 12 months, it may not make sense for an investor with a longer time horizon to follow it. Also, does the recommendation fit in with the investor’s goals? An investor who avoids petroleum stocks might not follow an overweight recommendation for oil companies.
Also, it’s important to realize that an overweight recommendation is, in essence, a recommendation away from diversification, which can be one way to help protect a portfolio from market risk. An investor who prioritizes diversification in their portfolio may want to consider buying an overweight security, while not becoming overweight in that area.
When an analyst gives a stock an overweight rating, broadly speaking it could be a good thing. If the analyst is correct, and the stock is indeed poised to perform better than its benchmark — maybe even better than the market as a whole — investors may want to buy that stock. But the necessary caveat is that it all depends on context — the context of the market, and the context of an investor’s portfolio overall. You don’t want to buy a stock that could throw your allocation off, and make your portfolio overweight in a way that’s not ideal.
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