Comfort Zone Investing: Overweight doesn't mean speculate

Ted Allrich is the founder of The Online Investor and author of: Comfort Zone Investing: Build Wealth And Sleep Well At Night. In this weekly column, he'll offer advice to investors who are just getting started.

You may see a recommendation to "overweight" a stock or sector. An analyst is bullish on a stock or group and feels buying more than usual will be rewarded. It may or may not come true. While it's a good idea to overweight at times, it should never be done in excess, to a point where you're putting too much of your portfolio in one stock or group of stocks. That's when overweight turns into speculate.

A rational approach to building a portfolio is to have at least five different sectors, ones that aren't correlated. There are different definitions of sectors but there are usually between 10 and 15, depending on what publication or expert you use. These sectors are categorized into broad groups, such as Healthcare, Technology, Manufacturing, etc. Within each sector are many industries. Value Line defines 98 different industries, ranging from Coal to Auto Parts to Water Utility to Beverages. Healthcare, as one example of a sector, has pharmaceutical companies, hospitals, medical devices, anything associated with health. Technology has a broad spectrum as well, encompassing everything from computers to wireless communication.

By holding at least five different, uncorrelated sectors, an investor will minimize risk. When interest rates go higher, it will hurt housing but won't affect drug stocks. Or if commodity prices go up, such as corn, raw materials for food makers increases, but housing prices won't feel it. The idea is to balance investments so that no one sector will cause too much damage if it's coming under siege.

Sectors are sometimes divided into "defensive stocks" and "cyclical stocks." Defensive stocks are ones that aren't hurt as much by a falling market because they have a large capital base and a strong market position. Cyclical stocks, by far the majority, are ones that move with the cycle of the market. When the economy is booming so are these stocks. When it's faltering, these stocks stumble along with it.

Within each of the five or more sectors well-balanced investors own are many stocks from which to choose. Take the Financial sector. Investors can buy Wells Fargo & Co. (NYSE: WFC), Washington Mutual Inc. (NYSE: WM), AIG (NYSE: AIG) and Citigroup Inc. (NYSE: C). That's a bank, a thrift, an insurance company and a financial services company. If you consider manufacturing, you could own General Motors (NYSE: GM), Deere & Co. (NYSE: DE), US Steel Corp. (NYSE: X), Sony Corp. (NYSE: SNE), and/or Dell Inc. (NASDAQ: DELL). That would put an auto company, a tractor maker, a steel company, an electronics firm, and a computer manufacturer in your portfolio.

Smart investors have a balance within these sectors, putting equal amounts of money into each stock. However, when they want to overweight the sector, they will stretch the boundaries, investing more into one sector than normal, perhaps going from 20% of the portfolio to 25%. Then within the overweighted sector they will add more stocks or increase existing positions equally. In other words, they don't buy one stock and yell "Yeehaw!" That's not overweighting. That's stupid.

Keep the idea of balance always in mind. Overweighting is good, but it shouldn't be done with abandon. Put more money than normal in one sector or stock when it appears oversold and ready for a bounce. But not so much that if it isn't, the consequences aren't devastating to your portfolio's performance or to your psyche.

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