There are many ways to invest in the stock market, and investors use a variety of methods to construct portfolios and to pick stocks. However, when it comes to investing, there are generally two main schools: Top-down and bottom-up. Which method is easier or more superior? Should it be tuned to a person’s intellectual capability and psychology?
What is top-down and bottom-up?
Let’s first define what these terms mean. Top-down investing refers to the process of looking at the macro-environment as a starting point, then selecting the areas with the best growth or most stability. Next, the investor will narrow down to a few industries which he thinks are performing well or are likely to perform well in the medium-term. Within each industry, he would then filter out the best performing companies which show promise and steady growth. The investor will then choose a smattering of companies from each industry in which to invest in.
Thus, the top-down approach can be summarized as such: We start from the economy, go down to various industries, and then narrow down the companies within each industry. We start from the “top” and then drill “down.”
Bottom-up investing, on the other hand, implies starting from the “bottom” (the companies themselves), and involves financial and business analysis to find great companies to invest in. The investor may use a filter to look for strong financial metrics, such as a high return on equity, a good dividend yield and superior profit margins. These filters then generate a list of candidate companies which satisfy the criteria, and the investor then delves further by reading more on the companies he is interested in.
This type of analysis typically involves selecting companies based on a few key traits: A strong competitive advantage, an ability to innovate, and the presence of good cost controls. Bottom-up investing is also done without much reference to the macro-economic environment or specific industry characteristics.
The better school
So which method is superior? Let us look at the two styles in terms of effort-needed and information-required, as these directly impact the time we have to spend.
For the top-down approach, we would need to glean information on the economy, interest rates, exchange rates and other macro-economic data. Following which, we would have to gather information on various industries and how well each is doing. Finally, we would need to look into the promising companies within each industry that we have chosen, and review their financials, prospects, and strategies. Sounds like a whole ton of work to me!
For the bottom-up approach, we would need to be equipped with our screens and filters in order to obtain the search results we want. After which, we need to read up more on each company that interests us by going through their annual reports and other corporate documents. We may need to read a little about the industry in which the company is in, but we can generally ignore macro-economic data as it would have limited impact on the company we choose, as long as the company exhibits the strong numbers, ratios, and traits mentioned earlier.
The answer is therefore obvious – the bottom-up investor would need to spend less time and also require much less information as compared to the top-down investor. This also lessens the chances of making mistakes along each step of the way.
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