Top-Down, Bottom-Up, Half-Full...?

03/28/2012 8:45 am EST

Focus: MARKETS

Patrick McKeough

Editor, Successful Investor

As the old saw goes, whether the glass is half-full or half-empty depends on whether you're pouring or drinking...can the same be said each side of the investing coin? So asks Pat McKeough of TSI Network.

In the early chapters of any good book on fundamental stock market advice, you will come across the two basic ways to make investment decisions: bottom-up and top-down.

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 Y2K scare that gripped the world in late 1999, the Internet stock boom, avian flu, or the future of the electric car.

In any one year, top investment honors often go to a top-down advisor. When enough people offer opinions about the future, after all, somebody has to get it right.

But nobody gets it right every time. Anybody who did would eventually acquire a measurable share of all the money in the world, and nobody ever does that. That’s why there’s a lot of turnover in the top ranks of top-down investors. One bad guess can ruin a previously enviable record.

Over periods of five years and beyond, therefore, top investment honors 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 provide greater tax deferral and lower brokerage costs.

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 good current example is the intense interest that built up for many months over the European debt crisis and a possible Eurozone economic collapse, if not a worldwide collapse. Week after week, in every edition of every newspaper you could find one or more articles delved into how that might occur, and the devastating financial results that would follow.

This widespread attention tends to get priced into the market, as traders say. In other words, investors react to this kind of potential calamity by paying a little less for investments than they otherwise would. As a result, you can buy good investments for less money.

In the past few months, European authorities have crept tentatively, and often nervously, towards a final resolution of the crisis in Greece. Even so, the markets have been rising and the predicted collapse has not occurred.

To put it another way, if the risk of an economic collapse in Greece—or Portugal or Spain or Italy—tempts you to sell all your stocks and go into cash (as traders say), keep one thing in mind: you’re not the only person who knows about that risk.

Read more from TSI Network here...

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