Overweighting Could be a Danger to Your Investment Portfolio

February 6, 2024
1:33 pm

Recent financial reports by big tech companies show huge profits. These results bolster the importance of AI and cloud computing in today’s modern world. Investors are drawn to big tech companies of the future and are eager to add the tech sector to their investment portfolios. But this leads us to ponder if there is such a thing as overweighting an investment portfolio with a particular sector that is delivering high returns.

Can you overweight a portfolio with a particular stock?

We all have a particular stock that we favour, and the potential for high returns is promising. It is easy to want to add a higher percentage of this stock to a portfolio. This could, however, have the reverse effect if this stock suddenly plummets. Unless we are experienced traders buying and selling stock, it is best to stick with diversified funds that grow over the long term. Rather use a financial advisor who actively manages a portfolio to keep track of sectors and stocks doing well.

What is Overweighting?

Overweighting is when a portfolio has a higher percentage of a particular sector than average. This occurs when a specific stock or sector performs well, and the investor increases the percentage of this stock in their portfolio—for example, increasing the percentage of tech stock currently producing high returns or investing in more stable bonds to protect against volatility.

Dangers of Overweighting an Investment Portfolio

While overweighting on a well-performing stock over the short term could potentially boost the earnings of a portfolio, it could reduce the overall diversification of a portfolio, making it more vulnerable to market risk.

• Inconsistency

Even the most experienced experts cannot accurately predict or time the markets. It is easy to make mistakes and potentially cost the client a fortune. For example, adding a larger percentage of a sector’s stock (increase energy stock from 15% to 30%) to a portfolio could deliver excellent returns over the short term (generating a rate of 15% p.a). Still, if that particular stock’s performance suddenly drops (from 15% down to 4%), there will also be more significant losses to the portfolio because the percentage is higher.

Overweighting could benefit over the short term, but it is risky and could cause losses.

• Reduces Diversification

Increasing the percentage of a particular sector or stock in a portfolio reduces the overall diversification and increases risk.

• Based on Opinion

Analysts or wealth experts have opinions on which stock is a good investment. Investors should consider the views of experts as well as market data, earnings reports, past price performance, profit margin, and company management before making any investment decisions.

Your Risk Profile Determines Your Weighting

The type of tolerance an investor has for risk will determine the portfolio’s weighting. For example, someone with a more conservative approach to investing would have a 50/50 weighting of equities to bonds.

This reduces volatility and spreads risk. A more adventurous investor might prefer an 80/20 weighting of equities to bonds, which carries greater risk but also the chance of higher returns.

Protecting Your Investment Portfolio Through Diversification

No matter what an investor’s risk profile is, it is vital that diversification plays a significant part. We look at the riskier investor with an 80/20 split. Looking at the 80% of equities, you would think that 80% is heavy and could be considered overweighting.

The 80% weighting itself is not the issue, as long as the equities invested in are diversified across various sectors and economic regions to spread risk. It is only when a large portion of the 80% of equities are invested in one particular kind of sector or stock that overweighting occurs.

Long-term diversified portfolios that earn compound interest are the foundation of building wealth over time. Overweighting investing could be considered a supplemental source of income for the everyday investor wishing to dabble in the stock market.

While overweighting a portfolio could benefit the bottom line, it is difficult to time the markets and could go the other way.

Always consider the impact that overweighting will have on a portfolio and consult with a financial advisor before making any investment decisions. Each person’s financial needs, goals and risk tolerance are different, which should be considered when deciding on overweighting.

Please note, the above is for educational purposes only and does not constitute advice. You should always contact your advisor for a personal consultation.
* No liability can be accepted for any actions taken or refrained from being taken, as a result of reading the above.