Reviewed by Sep 30, 2020| Updated on
Underweight refers to the stock rating in an investment portfolio. A rating system can either be a three-tiered or a five-tiered system. A three-tiered rating system includes overweight, equal weight, and underweight stocks. Similarly, a five-tiered rating system includes buy, overweight, hold, underweight, and sell stocks.
When a stock is rated underweight, the advisor is implying that the investor should consider lowering the holding of such stocks to weigh less in the portfolio.
Consider an example wherein an investor's portfolio is diversified in such a way that 25% is allocated towards stocks of the defense sector, 50% towards stocks in the retail sector, 10% in pharmaceuticals, and 15% in manufacturing.
The investment advisor informs the investor that stocks in the pharmaceutical are underweight. The advisor is actually implying that only a small percentage of the stocks should be in pharmaceuticals.
This is because the stocks in the pharmaceutical sector are expected to generate lesser returns when compared to the average total return of the investment advisor's expectations.
A portfolio manager can choose to rate stocks as underweight if they believe that the stocks will underperform with respect to the other securities in the investment portfolio.
Let us assume that particular stocks in the portfolio have a weight of 15%. Now, if the analyst expects the stock to underperform during a certain period through the risk-adjusted analysis of the stock, he can choose to reduce the percentage of allocated to say 10% during the period.
The remaining 5% that is left out can now be directed towards those stocks which the analyst expects to perform well during the same period. In return, this will increase the overall expected return for the investor's portfolio.