Both methods have some strengths and weaknesses.
Another way to frame this issue is to ask: Do you take a top down or a bottom up approach to selecting stocks for investment?
The emphasis here is on long-term investing as opposed to trading, which is more interested in exploiting price changes in the market and not holding stocks for long-term investing.
Investors that begin with the big picture are said to be top-down investors, while those who begin their search as the company level are considered bottom-up investors.
If you are not familiar with these terms, they describe a methodology or systematic way of identifying stocks for investment.
Both approaches have the same goal, but come at the challenge differently.
This article looks at the top-down approach to stock selection. A subsequent article will cover the bottom-up approach.
At its most extreme, top-down investing goes from the big picture to the individual stock or, stated another way, from the macro to the micro.
The top-down investor looks at the world economy and develops a sense of its health - where it is strong and weak.
Here are some questions the top-down investor asks:
- Which economies are expanding and which are troubled
- Which regions show growth prospects
- What industries are growing in the global economy
Investors look at changes in gross domestic products of foreign markets for clues about the strength and direction of those economies.
They also must consider geo-political unrest, war and other factors that may affect the countries economy.
From there the focus narrows to the U.S. economy with emphasis on the major indicators such as interest rates, employment, and inflation.
This analysis gives the investor a picture of the economic environment and how it will affect stock sectors.
A further narrowing of focus draws the investor's attention to the major stock indexes.
What the investor wants to know is how healthy is the overall market - is it overpriced (high PEs for major indexes), for example.
What has been the 52-week trend in prices? Is the market in a bear or bull cycle?
This market information helps the investor identify sectors and companies that will have a better chance to out perform the market under these conditions.
This is the final step: identifying companies in industries that will likely prosper under current market and economic conditions.
Of course, investors could reach this point and discover the market is over-priced for the risk and unlikely to grow substantially in the near future.
This would suggest a lower exposure in equities or selected niches that may proper even in a sour market.
This method of picking stocks is no more fool proof than any other method.
You must make many judgments along the way and many of your assumptions could prove to be wrong. All of which means you could miss significant opportunities or be on the wrong side of the market.
However, most investors don't rely on only one method of picking stocks. Top-down investing is a disciplined, logical way to approach the problem, but it is not the silver bullet of stock picking.
Strengths and Weaknesses
The top-down investor's approach has several strengths and weaknesses.
- The assessment of global markets and economies is challenging even for experts
- Media often report with American-biases that may fail to predict problems or see opportunities in other countries
- Even looking at U.S. stock sectors, investors may have favorites that receive a less critical look
- Even with the challenge of assessing the global economy, following experts in this area helps put opportunities in perspective
- The "big picture" helps investors overcome bias
- Places an emphasis on looking at companies in the context of the economy as well as it peers
For information on bottom-up investing click here.