Investing is pretty similar to playing chess - behind every move there should be a well-thought-out strategy.
Short-term traders often use technical analysis to find speculative opportunities, while long-term investors use fundamental analysis to spot undervalued companies.
When it comes to stock-picking using fundamental analysis, there are two common strategies: top-down and bottom-up investing.
What is Top-down investing?
Top-down investing starts with a broader view of the overall economy, taking into account interest rates, inflation, and GDP levels.
After analyzing various macroeconomic factors, investors could identify the sectors and industries that may offer investing opportunities and then would select stocks, funds or other securities within the promising industries.
The logic behind top-down investing is simple: if macro factors are favorable for a specific industry, it may be wise to invest in a specific stock from that industry.
Most top-down investors focus on capitalizing on large trends and tend to take advantage of exchange-traded funds (ETFs) rather than individual equities to the goal.
What is Bottom-up investing?
The bottom-up investing method is the opposite of top-down investing as it immediately dives into the analysis of individual stocks.
Investors who use such an approach primarily concentrate on microeconomic factors, such as a company's earnings and PE ratio but will also widen to the macro factors that impact the stock price.
Bottom-up investing requires investors to dig deep into the company they want to invest in before pulling the trigger.
Most bottom-up investors focus on the attributes of a company rather than the environment surrounding them when they're building their portfolio. And they tend to be buy-and-hold investors.
Which strategy is right for you?
Top-down investing typically follows market cycles. Merrill Lynch's Investment Clock stated that the economic cycle could be divided into four stages: reflation, recovery, overheat, and stagflation.
If you prefer to invest from the big picture to increase the resilience of your portfolio, then top-down investing should be for you. For example, when the market sinks into recession-shrouded bearish sentiment, it's important to hedge your portfolio against sectors that have survived the recession, such as the staples sector, or sectors that benefit from inflation, such as the energy sector.
For investors with ample cash and a sensible asset allocation, a huge buying opportunity is being created when the market experiences a historic pullback. You've been a solid researcher; it's time to take a bottom-up strategy to capture these specific opportunities.
The bottom line
It's essential to point out that you won't be immune to risks no matter what strategy you choose and how much research you do.
This is why asset allocation is important, as controlling risk is crucial in investing.
Furthermore, although these two strategies have different priorities when considering influencing factors, are not mutually exclusive. No one method can guarantee perfect results. Therefore, investment strategies often work together to make better decisions.