If in the past, you have frequently come across fund managers who speak about how they invest in stocks, you have probably heard a lot of them employ the top-down approach. At first, they will make a decision on how to split up their portfolio; some of their investment will be allocated to certain stocks and some will be allocated towards certain bonds. Once this decision has been made, they may then go onto decide on the particular mix of domestic and foreign securities. The next step they might take involves making a choice about which industries they should invest in. The analysis of certain securities will only happen after all of the other things have been decided on. If you use common sense to analyze this type of approach, you should instantly come to see how irrational it actually is.
If low P/E stocks come with highly unstable earnings or a lot of debt, there might be some justification between the spread amongst the yield of earnings and the yield of the long bond. However, a lot of low P/E stocks have earnings that are much more stable compared to their kin with high multiples. Several earnings do come with a lot of debt. But still, in recent years, someone could locate stocks with earnings that yield up to 12%, dividend yields of up to 5%, and with no debt, even though several low bonds yielded. Such a situation could happen if investors chose to shop for bonds without taking stocks under consideration. This would not make much sense and is similar to shopping for vans without taking trucks or cars unto consideration.
Every investment is practically a cash-to-cash operation, so they need to be judged by one measure alone: the overall discounted value of the future cash flow. Because of this, it would be nonsensical to follow a top-down investing approach. Starting a search by deciding on an industry or kind of security would be similar to a manager deciding on right-handed or left-handed pitchers before checking every individual player. The choice is not only hasty but also incorrect. Regardless of whether pitching left-handed happens to be more effective, general managers aren’t comparing oranges and apples; they are comparing pitchers. The inherent disadvantage or advantage that can be found in the handedness of a pitcher can be focused onto some ultimate value. Because of this, the handedness of a pitcher is only a single factor that should be taken into consideration rather than a binding selection. This also applies for the kind of security. It is not more logical or more necessary for investors to prefer every bond over every stock than it would be for general managers to prefer righties over lefties. You do not have to figure out whether bonds or stocks are attractive; you just have to figure out if particular bonds or stocks are attractive. On that note, you don’t have to find out whether the stock market is overvalued or undervalued; you just have to find out of certain stocks are undervalued. If it is, purchase it right away without giving the market another thought.
Obviously, the prudent approach when it comes to investing would be evaluating every individual security compared to the other ones, and just to consider the kind of security as it affects every individual evaluation. Top-down approaches to investing would be unnecessary hindrances. Several highly smart investors use it and then overcome it; there is absolutely no need to go through that yourself.
