Which do you think leads to better performance: the bottom-up approach or the top-down approach? The answer may surprise you.

Successful investors generally understand that you have two basic ways to make investment decisions: the bottom-up approach and the top-down approach.

Here’s a look at these two approaches:

The bottom-up approach

When you use the bottom-up approach, you focus on what’s going on in the investment world. You might call this descriptive finance. Before you decide to buy or sell a stock, you delve into its earnings, dividends, sales, balance sheet structure, competitive advantages and so on.

Over periods of five years and beyond, top investment honours mostly go to a member of the bottom-up 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 provides greater tax deferral and lower brokerage costs.

It pays to focus on the fundamental bottom-up investment approach, but you need patience to profit from it. Investors and markets may underestimate or fail to recognize good or bad fundamental information for lengthy periods. They may fail to take hidden assets into account for years. Ultimately, though, good investments go up and bad investments go down.

How the top-down approach differs from the bottom-up approach

“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.

If you lean toward the top-down approach—you might call it predictive finance—you downplay what’s currently going on. Instead, you focus on trying to figure out what happens next. Mostly you do that by zeroing in on external factors such as stock-market trends, the economy, interest rates, gold and so on. Or, you may focus on a single key trend, event or detail.

Still, in any one year, top investment honours often go to a top-down advisor. When enough people offer opinions about the future, after all, somebody has to get it right. But there’s a lot of turnover in the top ranks of top-down investors. One bad guess can ruin a previously enviable record.

The top-down approach appeals to beginning investors. It simplifies things when you have not yet learned how little you know. If you must dabble in top-down, the early part of your investing career is a good time for it, because you mostly have less money to lose.

How to become a bottom-up approach investor

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.

If you diversify as we advise, you improve your chances of making money over long periods, no matter what happens in the market.

For example, manufacturing stocks may suffer if raw-material prices rise, but in that case your Resources stocks will gain. Rising wages can put pressure on manufacturers, but your Consumer stocks should do better as workers spend more.

If borrowers can’t pay back their loans, your Finance stocks will suffer. But high default rates usually lead to lower interest rates, which push up the value of your Utilities stocks.

As part of their portfolio diversification strategy, most investors should have investments in most, if not all, of these five sectors. The proper proportions for you depend on your temperament and circumstances.

For example, conservative or income-seeking investors may want to emphasize utilities and Canadian banks in their portfolio diversification, because of these stocks’ high and generally secure dividends.

More aggressive investors might want to increase their portfolio weightings in Resources or Manufacturing stocks. For example, more aggressive investors could consider holding as much as, say, 25% to 30% of their portfolios in Resources.

However, you’ll want to spread your Resource holdings out among oil and gas, metals and other Resources stocks for diversification and exposure to a number of areas.

The more brokers and the media praise popular stocks, the higher investor expectations are raised—and the farther they have to fall

When investor expectations are high, it pays to be skeptical—and wary. That’s why we advise downplaying popular stocks that are in the broker/media limelight.

When that limelight focuses on a stock, it tends to push up investor expectations.

When popular stocks fail to live up to investor expectations, as they inevitably do from time to time, their stock prices can plunge.

Do you use the bottom-up approach to investing? Share your story with us in the comments.