When it comes to investing, there’s a number of key decisions an individual must make before moving onto making actual transactions in their portfolio.
Number one on the list should be defining your asset allocation strategy. If you skip this step, you will inevitably, sooner or later, find yourself grasping at different opportunities on Wall Street with no clear goal in mind. There’s no shortcuts to success when it comes to portfolio management, and having a well-defined asset allocation strategy is an all too often overlooked step in the investment process.
Simply put, if you don’t have a clearly defined asset allocation strategy, you’re probably speculating in the markets.
Next on the list is determining which security selection approach best aligns with your goals, skills, and risk-preferences. There’s generally two schools of thought when it comes to security selection, and they are: Top-Down and Bottom-Up.
Before we dive in, let’s be clear that the end goal of top-down and bottom-up analysis is essentially the same — that is, identifying which stocks to buy. The difference between these two approaches boils down to how you start with regards to finding the stocks you intend to purchase.
What is Top-Down Analysis?
If you elect to follow a top-down analysis approach you will generally take the following steps in order to arrive at the conclusion of what stocks to buy:
- Macro-Economic Analysis: You must start with the “big picture” here. This means considering and determining where the global economy is in terms of the business and credit cycle.
- Sector Analysis: After you determine where we are in the “big picture” cycle, you will then have to narrow down what sectors are best poised to thrive in the current, and more importantly the upcoming, economic environment.
- Peer Group Analysis: After you narrow down the list of sectors you want to focus on, it’s time to start comparing companies within the same industries in an effort to determine which one offers the best potential return for your investment.
As you can see, there’s quite a few steps, and difficult questions, involved with top-down analysis. In our view, this leaves room for error at each and every step; in other words, if you make wrong assumptions at the macro level, your mistakes will inevitably lead you to less-than-ideal sectors to focus on, and ultimately force you to pick from companies that are not well-positioned for the current (or upcoming) environment period.
What is Bottom-Up Analysis?
The steps for bottom-up analysis are as follows:
- Company Specifics: At its core, bottom-up analysis is not concerned with where we are in the macro cycle or what sectors are poised to thrive. Instead, bottom-up analysis is concerned solely with a company’s specific fundamentals. For income investors, this includes focusing on how long a stock has been paying dividends for, years of consecutive increases, and the average annual rate of those distribution increases.
In our view, the beauty of bottom-up analysis is illustrated quite clearly above — there’s only step involved. That’s not to say that bottom-up analysis is any easier than top-down; instead, it simply means that there’s less steps involved before you arrive at the same conclusion of what stocks to buy.
The difficulty in bottom-up analysis lies in having a very deep understanding of a specific firm’s fundamentals. You have to know a company like the back of your hand before you can feel comfortable with making an allocation. Another difficulty is having a starting list of “solid stocks” to help steer what firms you will study — our Best Dividend Stocks list is a great resource for anyone looking to go down the bottom-up analysis route.
The Bottom Line
As with everything in life, there are advantages and disadvantages to both security selection approaches. With top-down analysis, your opportunity set is bigger, although you have to answer more questions correctly before you can even begin to analyze specific companies. We prefer bottom-up analysis because it’s not concerned with having to figure out where the market and economy might be headed next; instead, we have to separate fundamentally-solid companies from those that are lacking the characteristics embraced by conservative dividend investors.
There’s no reason your investment process can’t incorporate both of these approaches. Just be sure to know why you are proceeding with any type of analysis before making allocations — the real value lies in understanding why you are doing something the way that you are, and not just going through the motions.
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