Putting together a stock or investment portfolio is like cooking. You measure the amounts of different ingredients so that correct portions of ingredients result in a delicious dish. The different weights, or portions of stocks, in your portfolio have a lot to do with how your investments will taste over the long term -- either the sweet taste of wealth, or the bitterness of underperformance. There are several ways the market uses weightings.
Asset Allocation Weights
If you invest using mutual funds or exchange-traded funds, part of your focus should be on the asset allocation between stock and bond funds. Your asset allocation is the weighting between stock funds and bond funds. For example, as a young couple you might choose to be 70 percent in stocks and 30 percent in bonds. As you grow older, you should rebalance the portfolio on a regular basis so the selected weightings change. If the weight of the bond side has increased to 35 percent, you would sell some of your bond fund shares and invest the money into stock funds.
Market Cap Weighting
Most stock market indexes use market cap weighting to determine the value of an index. Market cap is the dollar value of a company's outstanding shares. Using a market cap weight approach gives larger companies a bigger clout in an index relative to smaller companies. For example, the Nasdaq 100 stock index includes 100 of the largest non-financial stocks listed on the Nasdaq based on market cap The index is market cap weighted, so that the 10 largest companies account for almost one-half of the value of the index.
Portfolio Stock Positions
With a portfolio of individual stocks, the stock weights are the percentage value of each stock in the portfolio. If you own an equal amount of 10 stocks, then each has a 10 percent portfolio weight. Set a maximum position size for the stocks you own to avoid becoming overweighted in one stock and suffering the consequences if that stock loses a large portion of its value. The target weight of your portfolio depends on the number of stocks you plan to own. If you think that 20 stocks provide the market coverage and diversification you need, then each stock would start with a 5 percent weight. Or, you might set a 10 percent limit so that if one stock reaches the max weight, some of the shares would be sold and the money invested in an under-weighted stock.
One stock weighting mistake to avoid is to own too many stocks in the same business sector. For example, suppose you own equal weight positions in an Internet stock, a software stock, a computer stock and a fast-food stock. Your individual stock weightings are balanced. However, you are over-weighted in technology stocks. When an investor focuses only on stocks in sectors that he is familiar or comfortable with, he ends up with too much weight in those types of stocks. If that sector runs into problems, he could end up losing a lot of money because he doesn't have a strong enough position in other sectors to offset the losses.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.