Investment Strategies - "Top Down" and "Bottom Up" Investing
17 Jun 2002 14:53
By FundSource
You may have heard a lot about a "bottom-up" or "top-down" approach to investing. But can you explain the differences between the two? These two philosophies -- "bottom up" and "top down" -- are two very distinct and fundamentally very different philosophies for choosing investments with the best return potential.
That said, however, these two virtually opposite approaches can be melded together into a stock selection process that can, theoretically at least, lead you to some good investments.
Bottoms up
Let's start with "bottom up." Adherents of this approach would say that it's pretty much a waste of time trying to find good investments by capitalising on broad investing trends or movements in market sectors.
Instead, a "bottom up" investor would claim that the true path to good investments lies in trying to find individual investments that are attractive because of something particular to them -- i.e., their terrific growth potential, say, or the fact that their assets are selling for less than their intrinsic worth.
So an investor who practices the "bottom up" approach might screen through reams of stocks to find ones that look like a buy on the basis of their fundamentals.
For example, a stock might have much higher growth potential than other stocks in the same industry, or a company may be selling at a bargain price simply because its industry is out of favour and investors are ignoring the true earnings potential of this particular stock.
The point, though, isn't so much which factor the "bottom up" investor uses to select stocks, but that the analysis starts with the stocks themselves.
Or top down
A "top down" investor comes at investing from the exact opposite direction, looking more at the forest instead of the trees. The "top down" investor begins his or her approach to picking investments by looking at the economy or broad trends in society and then asking, What types of companies would benefit from these trends?
So, for example, a "top down" investor might say that since the huge baby-boomer generation is ageing and moving toward retirement, companies that provide products and services to older people should benefit from that trend. This might lead to, say, buying pharmaceutical stocks or health care shares or, for that matter, stocks of insurers that provide retirement annuities.
A "top down" investor may also make investments based on what he or she thinks lies ahead for the economy. So, for example, if a "top down" investor believed that a resurgent economy might re-ignite inflation fears, then he or she might consider buying gold or natural resource stocks. So a "top down" investor starts with a concept and then looks for stocks that are compatible with it.
Top or bottom? Try both
Which are you better off using? We don't think either approach is inherently better than the other, but there does seem a populist bias toward "bottom up" (refer Warren Buffet). They like this approach for two reasons. First, if you identify stocks that are good values based on some analysis of their fundamentals -- growth potential, asset values, whatever -- then eventually other investors will also see that value and reward you.
The second reason expressed why many investors prefer "bottom up" is that they believe it's tough to get in early with the "top down" approach. In other words, by the time you come to the conclusion that health care is the place to be, many other investors will already be there, and the wonderful future prospects for these stocks will already be reflected in their prices. (Of course, you can make the same argument about "bottom up," that true values are hard to find there as well. Point taken.)
Ultimately, FundSource thinks it helps to keep both approaches in mind. If your natural bias is toward "bottom up," remember that any values you unearth may be realised quicker if the stock is also in an industry that will benefit from an economic or societal trend. And if you're a "top down" type of person, it doesn't hurt to do some fundamental analysis of the specific stocks in the industry you believe will benefit from some broad economic or demographic trend. In short, even with investment philosophies, it never hurts to diversify and hedge your bets.
