Investors have two major ways to find new investments that are the top-down approach and the bottom-up approach.
From where I stand, both methods have their merit. In fact, the goal of each approach should be the same thing, that is, to find good investments in the vast world of stocks. But, at the same time, these two approaches are quite different.
With that in mind, let’s take a look at the key differences between these two strategies.
The top-down approach
Investors who use the top-down approach tend to take a broad view before focusing on a particular sector to find suitable investments. For instance, recent reports suggest that interest rates might increase soon. With that framework, top-down investors may look at industries that can benefit from interest rate hikes, as such the financial industry.
The focus then shifts towards companies that operate within the financial industry. This method allows investors to concentrate on growing industries, or companies that are primed to benefit from any macroeconomic changes.
In my opinion, the key advantage of the top-down approach is that investors can focus their energy and time on specific industries. That would be mean less time is wasted casting their net too widely.
On the flipside, investors who use this approach limit may themselves to certain industries, and may miss out on other investment opportunities. As a result, there may be investment gems that are missed out.
The bottom-up approach
In contrast, the bottom-up approach involves making investment decisions based on the individual attributes of a company. Here, investors will tend to overlook the broader economy and focus on companies that they think have strong fundamental characteristics.
To sieve out good companies, they avoid industry-specific screening but will be open to any company that meets their investment criteria.
The key advantage of this method is that investors can find good investments, regardless of the industry that it operates in.
However, as you might have guessed, the bottom-up approach can sometimes be taxing and time-consuming as investors might have sieve through a large number of companies to find the few that are worth investing in.
A Foolish takeaway
Whether it is top-down or bottom-up, both methods have its pros and cons. As investors, we might want to consider employing the stock screening approach that suits our investment style. After all, the investor’s goal is to find the investments that can earn good returns in the stock market.