Believe it or not, investing can be a lot like putting your wardrobe together. You can mix and match concepts and themes to give your portfolio your own personal flair. Of course, putting your signature on your portfolio shouldn't come at the risk of returns. A portfolio that is out of style isn't going to help you achieve your financial goals, but knowing what investment style suits you best is vital to building a stunning financial ensemble.
There are two dominant schools of investing thought that are used by fund managers and other so-called experts: Bottom-Up and Top-Down. Fortunately for us regular investors, both of these are fairly easy to understand, and the experts don't have a monopoly on them. So we can use them, too.
The downside of bottom-up and top-down investing is that they are somewhat difficult to combine in one portfolio at the same time. While it may seem like combining the two in unison could act as a hedge, using both approaches simultaneously can have adverse effects on your overall returns during extreme market conditions.
For example, if your portfolio consists of 10 different holdings and you want exposure to both styles, you probably don't want five holdings that are bottom-up and five that are top-down. It's probably best to overweight in favor of one approach. The good thing is if your outlook changes, you can adjust your holdings at anytime to lean in favor of one approach over the other. You can start out as a top-down investor but change over to bottom-up anytime you wish.
Let's take at both theories and figure out which one fits best in your investing closet.
Focusing on Stocks: Bottom-up Investing
Bottom-up investing is the approach that many “average” investors are likely to feel most comfortable with as it is most conducive to longer-term time horizons. The premise behind bottom-up investing is a focus on the quality of individual stocks and their ability to generate returns, rather than focusing on an entire industry or the impact of business and market cycles.
For example, you're thinking about investing in XYZ Corp., the largest fertilizer maker in the world. You've done your homework and find that XYZ holds dominant market share, pricing power and has new, innovative products in the works. These factors clearly give it an advantage over its competitors. You also think that the company is well positioned to weather commodities cycles and other potentially dire economic events.
The bottom-up investor would buy shares in XYZ based on some of the traits we just highlighted. He would not be swayed by market events or compelled to buy shares in any of XYZ's rivals simply because those stocks have lower prices. This style of investing puts emphasis on a good company's ability to deliver returns regardless of how poorly their industry or the market is performing.
Clearly, bottom-up investors are focused on a company's underlying fundamentals and this suits longer-term investors. Think along the lines of the great value investors such as Benjamin Graham, Warren Buffett and Peter Lynch. Much of their success stemmed from their ability to see “the forest through the trees” and realize that regardless of market or sector behavior, there are always at least a few strong companies to place bets on.
The Macro Approach: Top-Down Investing
On the other hand, we have top-down investing, which takes a much a broader view of the world and its investment opportunities. Rather than zeroing in on a specific stock as we did with the bottom-up style, top-down investing uses factors such global market conditions and trends and industry -specific research to generate investment ideas.
For example, a top-down investor may see that US markets are currently offering fairly average returns, but that Brazil is outperforming. So he turns his attention to Brazil. From there, he would evaluate factors such as the business climate in Brazil, GDP, recent market performance and what sectors are performing well there. After identifying the strongest industries in Brazil, the top-down investor finds what he believes to be the best companies and makes his bets accordingly.
Experts have and will continue to debate which approach is better at generating returns, and it's difficult to say which one is better for regular investors. We can explain it rather simply: In the hunt for strong individual stocks, it's best to implement the bottom-up theory, but when searching for the best sectors, use the top-down approach.
Investors need to know that top-down investing requires more leg-work than does bottom-up investing. This is obvious because we have to evaluate many more factors to put the odds in our favor with the top-down school. And while top-down investing doesn't necessarily work against long-term investors, it is important to remember that global economic conditions can change quickly and what is a beloved sector today can be thrown out of favor tomorrow. This means top-down investors need to constantly stay abreast of market events.
Conclusion: Same Goal, Different Methods
At the end of the day, both bottom-up and top down investing serve the same purpose: To bolster the strength of your portfolio. Since no empirical research exists about the efficacy of one approach over the other, it's hard to endorse one and malign the other. As we see so often in the investment world, picking between the two schools of thought is simply a matter of an investor's goals and risk tolerance. If one of these approaches was vastly superior to the other, then it is likely that only one would still exist.