When it comes to which investment strategies to employ, people generally fall into two camps: “bot- tom-up investing” or “top-down investing.” While both investment strategies have merits and drawbacks, incorporating them in tan- dem may help you achieve a balanced, diversified portfolio.
But first, what are bottom-up investing and top-down investing?
• Bottom-up investing: Evaluating companies based on their brand and product strength, regardless of what the market is doing.
• Top-down investing: Focusing on broad economic sectors to determine which may benefit from current and anticipated economic conditions.
Understanding top-down investing
A top-down investing strategy begins by looking at key economic factors, such as GDP, inflation, and interest rates. “You’re looking more at macroeconomic benefits and weaknesses,” said Scott Wren, a Senior Global Equity Strategist for Wells Fargo Investment Institute.
An investor employing this investment strategy will use this big-picture knowledge to select a promising country or region, and then analyze industries and sectors within that area. Once they find a favorable sector, they’ll select attractive companies operating in that field.
With this strategy, it’s important to look at “where the economy is going, and which sectors and companies are going to benefit from where the economy is going,” Wren said. For example, when consumer confidence is high- er and people are likely willing to spend more on furniture and other nonessential items, sectors such as Consumer Discretionary tend to perform better.
One advantage of top-down investing is that having a focus on the economy’s performance allows you to understand more about how individual companies operate. “Corporate earnings are a product of the economic environment,” Wren said, “and corporate earnings typically have a significant impact on a company’s stock price.”
Understanding bottom-up investing
A bottom-up investing strategy begins on the other end of the spectrum. Rather than surveying the global environment, investors start with individual companies. They may study the company’s balance sheet, income statement, or reports to learn its strengths, weaknesses, and overall financial stability. Once they find a strong option with solid prospects compared to others in its niche, they will invest in the company.
A potential drawback to the bottom-up investing strategy, however, lies in the risk of overlooking macroeconomic factors. Investors taking the bottom-up approach may not focus on the environment the company is going to be operating in, Wren said. A great company could have a solid balance sheet and income statement, but if it enters an environment that is not ideal for its growth and performance, its bottom line could suffer.
Finding a balance
When it comes to investing, “the ideal situation is to have some combination of top-down and bottom-up investment strategies,” Wren said.
It’s good, on the one hand, to understand an individual company before investing in it. By understanding its financial reports, you increase your knowledge of whether or not the firm is in a solid financial position or if it has a lot of debt relative to its peers.
At the same time, having an understand- ing of where the economy is going is key, adds Wren. Some companies are more sensitive to changes in the environment than others. Utility stocks, for instance, might remain stable in a down economy. “You’ll heat your home whether the economy is good or bad,” Wren said.
Judy Nagel is vice-president-investment officer for Wells Fargo Advisors.