A tops-down approach examines the macro-type factors of the economy first. Then you work your way through lower levels of detail until you are finally looking at the individual investment. For instance, let’s say you are looking at allocating your portfolio towards stock. If you are a tops-down investor, you wouldn’t start thumbing through potential stocks to buy until evaluating other factors that will guide how much and what types of stocks to buy.
A bottoms-up approach means finding the absolute best security in your opinion, regardless of how attractive the overall markets appear at the time. The most common example of a bottoms-up investor is one who is looking to find the absolute best stock that fits a given category or style.
Many factors drive the price of a stock beginning with the particular characteristics. These are virtually countless in number, but commonly include the company management, revenue growth, profits, dividend yields, etc. All of these things make an individual stock unique in nature, like fingerprints and no two are the same. The purpose is to identify opportunity by selecting a stock that has a “better” make-up than its peer group and that trades at an attractive price.
Issues outside the company are also important to the price movement of the stock. The sector of the economy is very important. What isn’t always intuitive or apparent is that the size of the company based on market capitalization also matters greatly. Size -large, mid- or small cap — and style — growth or value – go in and out of favor over time and the stocks that perform the best tend to belong to the size and style most in favor that day.
Now that you have a grasp on each approach, which one is more important? Ultimately, this is for you to decide which is right for you. Consider a study conducted by the University of Chicago and Benjamin King that objectively finds a disconnect investors place on each approach. The average investor tends to spend 80 percent of their time in the analysis of their individual stock holdings looking at income statements, balance sheets or whatever they deem important. However, the study demonstrates that 80 percent of the actual risk and return in the stock is attributed to those factors that are outside of the individual stock.
The biggest investment mistakes we find seem to repeat themselves every year. Perhaps the most common is becoming fascinated with the company. I have done it myself with Harley Davidson. Forcing yourself to focus on the big picture – the tops down – can be tiring and dull and as a result, commonly disregarded.
Joseph “Big Joe” Clark is a certified financial planner and the managing partner of the Financial Enhancement Group, LLC. Big Joe can be reached at bigjoe@yourlifeafterwork.com, or (765)-640-1524.
