Most investors struggle with the art of picking stocks. Should they base their decisions solely on what the company does and how well it does it? Or should they focus more on larger macroeconomic trends, such as the strength of the economy, to determine which stocks to buy? There is no right or wrong answer. However, investors should develop systems that help them achieve their investment goals.
The second option mentioned is referred to as the top-down investing approach to the market. This method allows investors to analyze the market from the big picture all the way down to individual stocks. This differs from the bottom-up approach, which begins with individual stocks' fundamentals and eventually expands to include the global economy.
Start at the Top: The Global View
Because the top-down approach begins at the top, the first step is to determine the world economy's health. This is done by analyzing not only the developed countries but also emerging countries. A quick way to determine an economy's health is to look at gross domestic product (GDP) growth over the past few years and the estimates going forward. Often, the emerging market countries will have the best growth numbers when compared with their mature counterparts.
Unfortunately, because we live at a time in which war and geopolitical tensions are heightened, we must be mindful of what is currently affecting each region of the world. A few regions and countries throughout the world will fall off the radar immediately and will no longer be included in the remainder of the analysis due to the amount of financial instability that could wreak havoc on any investments. (For related reading, see: 5 Emerging Market Equity ETFs to Watch in 2018.)
Analyze the Trends
After determining which regions present a high reward-to-risk ratio, the next step is to use charts and technical analysis. By looking at a long-term chart of the specific countries' stock index, we can determine whether the corresponding stock market is in an uptrend and worth analyzing, or is in a downtrend, which would not be an appropriate place to put our money at this time. These first two steps can help you discover the countries that would match your wants and needs for diversification.
Look to the Economy
The third step is to do a more in-depth analysis of the U.S. economy and stock market's health. By examining the economic numbers such as interest rates, inflation and employment, we can determine the current market strength and have a better idea of what the future holds. There is often a divergence between the story the economic numbers tell and the trend of the stock market indexes.
The final step in macroanalysis is to analyze the major U.S. stock indexes such as the S&P 500 and Nasdaq. Both fundamental and technical analysis can be used as barometers to determine the health of the indices. The market's fundamentals can be determined by such ratios as price-to-earnings, price-to-sales and dividend yields. Comparing the numbers to past readings can help determine whether the market level is historically overbought or oversold. Technical analysis will help ascertain where the market is in relation to the long-term cycle. Use charts showing the past several decades and zone down the time horizon to a daily view. For example, indicators such as the 50-day and 200-day moving averages help us find the current market trend and whether it is appropriate for investors to be invested heavily in equities. (For related reading, see: Weighted Moving Averages: The Basics.)
So far, our process has taken a macro approach to the market and has helped us determine our asset allocation. If, after the first few steps, we find that the results are bullish, there is a good chance a majority of the investment-worthy assets will be from the equities market. On the other hand, if the outlook is bleak, the allocation will shift its focus from equities to more conservative investments such as fixed income and money markets.
Microanalysis: Is This Investment Right for You?
Deciding on asset allocation is only half the battle. The next integral step will help investors determine which sectors to focus on when searching for specific investments such as stocks and exchange traded funds (ETFs). Analyzing the pros and cons of specific sectors (i.e. health care, technology and mining) will narrow the search even further. The process of analyzing the sectors involves tactics used in the prior approach such as fundamental and technical analysis.
In addition to the mentioned tools, investors must consider the long-term prospects of the specific sectors. For example, the emergence of an aging baby boomer generation over the next decade could serve as a major catalyst for sectors such as health care and leisure. Conversely, the increasing demand for energy coupled with higher prices is another long-term theme that could benefit the alternative energy and oil and gas sectors. After the entire amount of information is processed, a number of sectors should rise to the top and offer investors the best opportunities.
The emergence of ETFs and sector-specific mutual funds has allowed the top-down approach to end at this level in certain situations. If an investor decides the biotech sector must be represented in the portfolio, he or she has the option of buying an ETF or mutual fund composed of a basket of biotech stocks. Instead of moving to the next step in the process and taking on the risk of an individual stock, the investor may choose to invest in the entire sector instead. (For related reading, see: An Introduction to Sector Mutual Funds.)
However, if an investor feels the added risk of selecting and buying an individual stock is worth the extra reward, there is an additional step in the process. This final phase of the top-down approach can often be the most intensive, because it involves analyzing individual stocks from a number of perspectives.
Fundamental analysis includes a variety of measurements such as price/earnings to growth ratio, return on equity and dividend yield, to name a few. An important aspect of individual stock analysis will be the company's growth potential over the next few years. Ideally, investors want to own a stock with a high growth potential, because it will be more likely to lead to a high stock price.
Technical analysis will concentrate on the long-term weekly charts, as well as daily charts, for an entry price. At this point, the individual stocks are chosen and the buying process begins.
The Positives of the Top-Down Approach
Proponents of the top-down approach argue the system can help investors determine an ideal asset allocation for a portfolio in any type of market environment. Often a top-down approach will uncover a situation that may not be appropriate for large investments into equities. The ability to keep investors from over-investing in equities during a bear market is the biggest pro for the system. When a market is in a downtrend, the probability of picking winning investments drops dramatically even if the stock meets all the required conditions. When using the bottom-up system, an investor will determine which stocks to buy before considering the state of the market. This type of approach can lead to investors being overly exposed to equities, and the portfolio will likely suffer.
Other benefits to the top-down approach include diversification among not only top sectors, but also the leading foreign markets. This results in a portfolio that is diversified within the top investment-worthy sectors and regions. This type of investing is referred to in some small circles as "conversification," a mixture between concentration and diversification.
The Negatives of Top-Down Investing
So far, the top-down approach may sound foolproof; however, investors must consider a few other factors. First and foremost, there is the possibility your research will be incorrect, causing you to miss out on an opportunity. For example, if the top-down approach indicates the market is set to continue lower in the near future, it may result in a lesser exposure to equities. However, if your analysis is wrong and the market rallies, the portfolio will be underexposed to the market and will miss out on the rally gains.
Then there's the problem of being under-invested in a bull market, which can prove to be costly over the long term. Another downfall to the system occurs when sectors are eliminated from the analysis. As a result, all stocks in the sector are not included as possible investments. Often a leader in the sector is overlooked due to this process and will never make its way into the portfolio. Finally, investors could miss out on bargain stocks when the market is near lows.
The Bottom Line
In the end, investors must remember there is no single approach to investing and every approach has its own pros and cons. One of the keys to becoming a successful long-term investor is finding a system that best fits your goals and objectives. (For further reading, see: Bottom-Up and Top-Down Investing Explained.)