Top Down Approach
A top-down investor lays more emphasis on sector, industry or theme rather than individual blue-chip stocks. Investors study the economic trends, and determine the industries and companies that are likely to benefit most of them.
Top-down investors will first look at the entire forest instead of specific trees and try to identify the main market theme ahead of the market in general. They believe that picking individual companies comes second because if the economic conditions are not right for the industry that that a company operates in, it will be difficult for the company to generates profits, regardless of how efficient it is. Nevertheless, such investors may sometimes miss good companies that are still performing well, even in depressed sector.
Bottom Up Approach
Bottom up investors conduct extensive research on individual companies. As long as the company’s prospect look strong, the economic, market or industry cycles are of no concern. In fact, the downturn in the stock market may provide investors with a good margin of safety to buy stocks at depressed levels and ride them up to big gains.
Thus, bottom up managers will buy stocks even though the macroeconomic and industry outlooks look uncertain. When the industry may be out of favour and most investors are ignoring the true earning of companies, bottom-up managers ca detect good and well-managed ones selling at prices that are far lower than their intrinsic worth.
Combination Approach
The top down and bottom up approaches are two distinct and fundamentally very different approaches to investing. Investors can combine the two approaches by applying top-down analysis on asset allocation decisions while using a bottom-up approach to select the individual securities in the portfolio.
As there is prediction and practice of major market crashes occurring every 10 to 15 years, the top-down approach may be more appropriate.
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