Is Your Portfolio Overweight? How to Rebalance and Diversify

Most financial advisers recommend a diversified portfolio of stock and bond investments for their clients to help manage risk. Why? Because when a portfolio holds many different kinds of securities, the rising value of one security may offset a decline in the price of another.

But sometimes market forces or other events can cause a portfolio to hold a larger portion of certain securities or asset classes than specified in the investor's target asset allocation.

When this happens, it can raise the overall risk level of the portfolio and move it out of alignment with the investor's investment plan.

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As a common example, many investors have an asset allocation target weighting of 60% stocks and 40% bonds. But if stock prices rise relative to bond prices, the actual weightings may be closer to 65% stocks and 35% bonds.

To restore the target weighting, many advisers use tax-efficient rebalancing strategies to sell shares of some of the stocks and invest the proceeds into bonds.

But there are other kinds of "overweighting risk" that can occur that may require more than a quick rebalance to resolve.

Single-company concentration

This is a common problem with 401(k) plans that offer company stock as an investment option or stock options as bonuses for employees.

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While owning shares of company stock gives you a personal stake in your employer's success, it also carries certain risks.

If a significant portion of your 401(k) plan assets is invested in company stock, and your company hits hard times, a large drop in the stock price could dramatically reduce the value of your retirement nest egg.

If you're about to retire, this might require you to rethink the way you'll be able to live during your golden years.

Don't believe this is likely to happen? Think about some of the big-name companies of the past that went bankrupt, like Eastern Airlines, Blockbuster, Enron, Lehman Brothers, Sears and Payless ShoeSource.

Unlucky employees who were still holding on to shares when these companies went under saw them tumble to a fraction of their peak value.

Pro tip: Most advisers recommend that investors have no more than 10% to 15% of their 401(k) plan assets invested in company stock. If your allocation is above this amount, consider selling some shares and investing the proceeds in other funds.

If you have vested stock options, you may want to exercise and sell some of them and use the proceeds to diversify your portfolio.

However, before you liquidate any stock options, it's important to be aware of any rules, restrictions and timeframes and consider any possible tax consequences.

A financial adviser or tax professional can help you better understand these issues.

Magnificent 7 overweighting

As of this writing, the seven largest U.S. companies in terms of market capitalization are, in alphabetical order, Alphabet (Google), Amazon, Apple, Meta (Facebook), Microsoft, Nvidia and Tesla. These companies — account for nearly a third of the total capitalization of the S&P 500.

Of course, most of the Magnificent 7 stocks have had a spectacular rise over the past two decades — the main reason why they've grown so large.

But if any one of them hits a rough patch, a big drop in their share price could put a major crimp in the performance of the funds that invest in them.

Most passively managed index funds are required to allocate assets to reflect the capitalization of the stocks in their associated indexes. That means that 30% or more of an S&P 500 index fund or ETF could be invested in these seven companies.

If you invested all of your money in one of these funds, your portfolio would be overweighted in these five companies, too.

And you can't necessarily avoid this problem by investing only in actively managed funds either. Why? Because many large-cap stock funds have significant holdings in these stocks as well.

Pro tip: You can reduce Magnificent 7 overweighting by including a greater variety of asset classes in your portfolio.

For example, consider adding small-cap and mid-cap stock funds, which generally don't invest in these stocks. Or add global exposure by investing in one or more international funds.

Sector overweighting

Ideally, your portfolio should have exposure to a wide range of industry sectors, from banks and financial services companies to retailers, health care companies, energy producers, construction companies and manufacturers.

That way, a downturn in one sector may be offset by stability in other sectors.

The problem is that when certain industries are outperforming other industries, sector overweighting can result.

Again, we can look at the Magnificent 7 stocks as an example. Since all of these companies are technology stocks, they alone can overweight your exposure to the technology sector.

Investing in several different stock funds doesn't necessarily reduce this exposure either, since many of these funds also have significant holdings in these technology companies.

Pro tip: One option is to add one or more sector-specific funds that offer more exposure to certain industries that are underrepresented in mainstream funds.

Must you always shed overweight?

Not necessarily. If you're decades away from retiring, you may not have an urgent need to sell your company shares or exercise stock options, particularly if your company appears to be poised for growth for the foreseeable future.

You may also not want to reduce the Magnificent 7 or high-tech sector overweighting by selling off highly appreciated stocks or funds if doing so will result in significant capital gains taxes.

And while overweighting represents one kind of investment risk, there are other kinds of risk that could affect the performance of your portfolio as a whole.

That's why it's important to consider how any potential adjustment to your portfolio could impact your overall investment strategy.

If you don't have the confidence to figure this out on your own, a financial adviser can work with you to make sure any move you wish to make will keep your investment plan on track.

Disclaimer

This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

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David Jaeger, CFP®, is a financial adviser at Canby Financial Advisors in Framingham, MA. David enjoys learning about each client’s unique situation and specific goals so that he can work with them to provide clarity and relieve stress. He earned his BA in History from Loyola University Maryland.

Advisory services offered through Canby Financial Advisors, LLC, an Investment Adviser registered with the U.S. Securities and Exchange Commission. SEC registration does not constitute an endorsement by the SEC nor a statement about any skill or ability.