Understand the difference between a top-down and bottom-up approach to investing and you will be prepared to make better investment decisions

Knowing the difference between a top-down and bottom-up approach to investing is a key strategy. I’ve often mentioned that I got my first investment job in 1964, at age 16, as a part-time assistant to an investment writer. My employer was generous with his time, and we often talked about the faults in my earliest investment ideas. One of the first of these talks centered on the upcoming 1964/1965 World’s Fair in New York City.

I had heard about a new stock issue from a company that planned to set up some restaurants at the fair. I figured it had to be a huge success. After all, the fair was attracting great attention in the media and at my high school. That was sure to attract huge crowds who had to eat. My employer thought about that for a moment, then said, “Yes, but you’re not the only person who knows that.”

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I didn’t know it at the time, but this was my first glimpse of the difference between a top-down and bottom-up approach to investing.

What is the between a top-down and bottom-up approach to investing?

Using the bottom-up approach, you focus on understanding what’s going on, rather than trying to predict what happens next. You could call this descriptive finance. You delve into earnings, dividends, sales, balance sheet structure, competitive advantages and so on. From there, it quickly becomes obvious that there’s an awful lot you don’t know about the risks in the investments you are considering. So you try to design a portfolio in which the risks offset each other.

Using the top-down approach (which you might call predictive finance), you downplay what’s going on now and try to figure out what happens next. You may zero in on trends in stock prices, the economy, interest rates, gold and so on. You may disregard most details. Or, you may focus on a single key trend, event or detail, such as the advent of 5G or even a World’s Fair or Olympics.

“Top-down” ideas and predictions get lots of attention in the media and in brokers’ research, so they tend to get “priced into” the market, as traders say. In other words, investors react to this kind of potential calamity or windfall by paying a little less or more for investments than they otherwise would.

Which type of investing can strengthen my portfolio?

The top-down approach appeals to beginning investors, when they have not yet learned how little they know. (That’s a good time for it, when you have little money to invest and can’t do yourself much harm.) By the time they build up enough of a stake to begin serious investing, most advisors and investors have settled on a mix of top-down and bottom-up. As years pass, successful investors tend to put more weight on bottom-up. They like the way it cuts risk.

Sometimes, a top-down idea acquires way too much influence on way too many investors. A classic example was the intense interest that built up for many months in 2012 over Greece’s debt crisis and a possible euro zone economic collapse, if not a worldwide collapse. Week after week, in almost every newspaper or online news source you could find one or more articles delving into how that might occur, and the devastating financial results that would follow.

Does using the bottom-up approach to investing get the best from your stock market picks?

In short, we think that most investors are far better off with “bottom-up investing” as opposed to “top-down investing.” Bottom-up is where you look closely at individual stocks and single out those with a history of sales and earnings, not to mention dividends. Then you buy a diversified, balanced selection of stocks that represent prosperous businesses with a strong hold on their markets.

We advise you to invest this way within the framework of our three-part Successful Investor portfolio strategy.

Over periods of five years and beyond, top investment honours generally go to a member of the bottom-up investing crowd. That’s partly because bottom-uppers tend to make fewer big mistakes. This lets their gains accumulate. This also leads to longer holding periods, which provide greater tax deferrals and lower brokerage costs.

Use our three-part Successful Investor approach to maximize your stock market gains

We recommend sticking to our three-part Successful Investor approach. In addition to its bottom-up focus, it calls for diversification by economic sector, and advises downplaying or avoiding stocks in the broker/media limelight.

1. Hold mostly high-quality, dividend-paying stocks.
2. Spread your money out across most if not all of the five main economic sectors: Manufacturing & Industry, Resources & Commodities, Consumer, Finance and Utilities.
3. Downplay or stay out of stocks in the broker/media limelight.

The top-down approach empowers bias behind investing. Can you think of situations where this bias is a positive attribute to the investment decision process?

What is your experience with a top-down approach to investing? Have you found it to be successful over long periods?