NEW YORK (CNN/Money) -
What do terms like "overweight" and "underweight" mean when used by brokers in their stock recommendations?
-- Herb Hoffman, Bryn Mawr, Pennsylvania
Investors of a certain age will remember the old E.F. Hutton ad campaign that had this signature line: "When E.F. Hutton talks, people listen."
Of course, given the sometimes ridiculous number of different systems brokerage firms have devised over the years to deliver their opinions about the prospects for specific stocks, you have to wonder if anyone really understood what old E.F. was actually saying.
Rather than just use simple phrases like "buy" or "sell," many firms resorted to an elaborate and often confusing continuum of phrases that seemed designed as much to hedge or tap dance around their true outlook as provide investors with clear guidance.
What the brokers wanted to avoid most, of course, was uttering that one dreaded four-letter word: sell. That would be too explicit, too definite, too...offensive to their investment banking clients.
The times, and terms, are changing
Over the last couple of years however, particularly in the wake of New York Attorney General Eliot Spitzer's investigation into the relationship between stock recommendations and investment banking activities, a growing number of firms have begun trying to couch their recommendations, if not in clear precise English, then at least in less confusing terms than before.
So instead of the former five-tier system that often ran from "strong buy" to "buy" to "market perform" to "market underperform" to the rarely used "sell," we see some brokerage firms moving to a three-tier system that uses phrases such as "overweight," "equal weight" or "underweight."
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In such a system, the "over" "equal" or "under" refers to a stock's attractiveness relative to other stocks in its industry or sector. So a stock that gets an "overweight" would typically mean that a stock is a better value than the other stocks the analyst covers in the same sector, while a stock that gets an "underweight" would be less attractive than other stocks in the same sector.
But the systems usually don't stop there. Often these individual stock ratings are combined with industry ratings that say whether the firm considers an industry or sector more or less attractive compared to a broad index such as the Standard & Poor's 500.
There may also be a recommendation as to what percentage of assets the firm recommends putting into various sectors of the market. So, theoretically, based on these various recommendations, you would be able to decide which sectors are the most attractive, how much of your portfolio to put into each sector and then which stocks you might want to buy (or sell, though they probably won't say sell) in each sector.
But is it clear?
So does this make investors any better off than they were before? Well, I suppose to the extent that the $1.4 billion global settlement on Wall Street and other regulatory actions are successful in eliminating investment banking considerations in securities analysts' recommendations then at least the ratings should be more independent than in the past.
Does that mean they'll be better at predicting a stock's future performance? Neither I nor anyone else knows. I do know this, however. I think it would be foolish for any investor to base his or her investments solely on the recommendation of a securities analyst, regardless of the firm.
At the very least, you would want to check the ratings from several different analysts, and then check the consensus ranking from all the analysts that cover a company. (To do that, click here. And even after doing that, I'd want to do my own independent research about the company, sifting through its financial statements, etc. so I can form my own opinion about its prospects.
If you're not willing to do that kind of work, then I don't think you belong in individual stocks in the first place. Or, to put it another way, "underweight" specific stocks in your portfolio and "overweight" mutual funds.
Walter Updegrave is a senior editor at MONEY Magazine and is the author of "Investing for the Financially Challenged." He also answers viewers' questions on CNNfn's Money & Markets at 4:40 PM on Monday afternoons.