We think investors using a bottom-up investment approach will realize higher long-term portfolio returns. Here’s why.

Our Successful Investor approach employs a bottom-up investment approach. That’s when you focus on what particular stocks are likely to do. You avoid the more complex task of figuring out the entire economy. That’s “top-down investing,” and it’s when you try to figure out the so-called “big picture” and pick out the stocks that are likely to profit best within it.

In any one year, the most successful investors tend to follow a top-down approach. But over longer periods—several years or more—the winners tend to be bottom-up investors. Bottom-up investors have fewer spectacular years, but they avoid a lot of devastating losses. So, they wind up with better long-term returns.

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Understand the bottom-up investment approach versus top-down investing so you can make smarter portfolio decisions

Using 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. You may disregard lots of details about stocks you buy. Instead, you’re likely to zero 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.

Top-down advisors can draw negative or positive conclusions from these trends. In the late 1990s, for instance, many investors took a highly positive top-down view of the profits that businesses could make by taking advantage of the Internet. Some of these investors routinely bought any new issue that claimed to have an Internet-based business plan. A handful of Internet stocks have done extraordinarily well since then, of course. However, the majority “crashed and burned”—generating miserable results if not total losses.

By the time beginning investors have built up enough of a stake to start seriously investing, most have settled on a mix of top-down and bottom-up. As years pass, successful investors tend to put more weight on bottom-up investing. They like the way it cuts risk.

“Top-down” ideas and events 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.

Of course, investors 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, good investments go up and bad investments go down, but both can seem to ignore the fundamentals for months if not years.

So, all in all, it pays to focus on the fundamental bottom-up Successful Investor approach—although you need patience to profit from it.

Use these factors to pick top stocks when you use a bottom-up investment approach

• Look for political stability. For example, mineral exploration is risky enough without the threat of expropriation or onerous taxes.
• Aim for well-financed stocks with no immediate need to sell shares at low prices, since that would dilute the interests of existing investors.
• Look for a sound balance sheet with reasonable debt.
• Watch for experienced management with proven ability to develop and finance a new business.
• Avoid stocks trading over-the-counter where regulatory reporting and so on is lax.
• Avoid stocks trading at unsustainably high prices due to broker hype or investor mania.
• Compare the market cap of the stock with the estimated value of its reserves, future product sales and so on.

Use our three-part Successful Investor bottom-up investment approach to profit over time

1. Invest mainly in well-established, dividend-paying companies, with a history of rising sales if not earnings and dividends.
2. Spread your money out across most if not all of the five main economic sectors: Manufacturing & Industry; Resources & Commodities; Consumer; Finance; Utilities.
3. Downplay or avoid stocks in the broker/media limelight. When stocks spend time in the limelight, they tend to become overpriced, and this leaves them vulnerable to a sharp downturn on any hint of bad news. Instead, look for stocks with hidden value that are less widely recognized—at least so far—as attractive investments.

Bonus tip: Diversifying your portfolio across the sectors will cut your risk

If you diversify your stock holdings following our Successful Investor approach, 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 pushes 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.

However, note that if you have Resource holdings, you should spread them out among oil and gas, metals and other Resources stocks for diversification and exposure to a number of areas.

Do you ever combine the approaches or bottom-up and top-down in your investing career?

What have you found to be a successful approach to investing? Do you focus on individual stocks or do you try to take in the big picture?